US Portfolio Strategist
24 July 2008
Must Read
Editorial
Shifting Sights to Semis 2
Semiconductors / Specialty Semiconductors — Recent Earnings and Industry Updates
We highlight earnings from TXN (we see downside as limited), SNDK (downgraded to Sell), and BRCM (high-quality 2Q). From an industry standpoint, we believe 330 will
43
Macro/Commentary
U.S. Equity Strategy
The Certainty of Uncertainty While Ignoring Reality Index Targets and Portfolio Weighting Recommended List 3 7 8
again form a support level on SOXX; we downgrade memory names, MU, QI, and SPSN to Hold; and reiterate Top Picks ONNN and TXN.
Proprietary / Proactive
Industry
Tobias M. Levkovich
Advertising Catriona Fallon
Cutting U.S. Ad Forecast, Reduce OMC to Hold; Q2 Ad Agency Preview 23
Small & Mid-Cap Strategy
A Faint Drumroll for Deal Activity SMID Target List 9 11
Large-Cap
Allegheny Energy Inc. (AYE) Greg Gordon
One of the Most Undervalued Stocks in the Utility Universe 25
Lori Calvasina
Economic & Market Analysis
Take a Hint from Financials Charts of the Week 13 17
Industry
Drugs & Ophthalmology John Boris
U.S. Major Pharmaceuticals Initiation of Coverage 27
Steven Wieting
On the Contrary
Mid-Cap
19
Fixed Income Strategy
Reality Check
Discover Financial Services (DFS) Bradley Ball
AXP's Negative Trends May Weigh on DFS Too 31
Michael Brandes / George Friedlander
Quantitative Strategy
Sector Performances During Bear and Post-Bear Market Periods 21
Insights
Industry
Independent Refiners Faisel Khan
The "Lost" Year but Value Remains: Lowering EPS and Targets 33
Keith L. Miller / Aline Sun
Large-Cap
International Business Machines Corp. (IBM) Richard Gardner
Another Clean Beat and Raise; Reiterate Buy 35
Top Picks Live!
Apple Reports Great 3Q, Reiterate Buy Listing Updated as of July 22, 2008 47 50
Industry
Machinery David Raso
Caterpillar: Still a Revenue Bull; Timken: Updating Estimates 37
Industry
Managed Care Charles Boorady
Cycle Bottoming? — A Look at UnitedHealth and WellPoint 39
Global Focus
The Globaliser
Featuring Nokia: Bearish Sentiment Overdone 51
Large-Cap
Merrill Lynch & Co. Inc. (MER) Prashant A. Bhatia
Assets Sold, Risk Down, Book Value Up, No Dilutive Raise 41
Bruce Rolph
Industry
Semiconductors / Specialty Semiconductors Glen Yeung / Craig A. Ellis
Recent Earnings and Industry Updates 43
See Appendix A-1 for Analyst Certification and important disclosures. Citi Investment Research is a division of Citigroup Global Markets Inc. (the "Firm"), which does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the Firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Non-US research analysts who have prepared this report are not registered/qualified as research analysts with the NYSE and/or NASD. Such research analysts may not be associated persons of the member organization and therefore may not be subject to the NYSE Rule 472 and NASD Rule 2711 restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. Customers of the Firm in the United States can receive independent third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at http://www.smithbarney.com (for retail clients) or http://www.citigroupgeo.com (for institutional clients) or can call (866) 836-9542 to request a copy of this research.
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Shifting Sights to Semis
The financial group finally caught a break (and a bid) this past week as the government circled the wagons around the GSEs and a few large banks posted quarterly earnings that were less bad than investors had feared. The sigh of relief was compounded by a drop in energy prices and the overall market responded in kind. All was not sunshine and roses, however. We are in the midst of the quarterly reporting season, and the strains on the overall economy from the credit crunch have been shining though in spots. This week was the technology sector’s turn. With this in mind, we highlight our Must Read, where semiconductors analysts Glen Yeung and Craig Ellis weigh in on recent earnings releases in the group and the implications thereof. We also highlight two contributions from the health care team: John Boris's initiation of coverage of the Drugs industry, and updates on United Health and WellPoint by Managed Care analyst Charles Boorady, who sees a potential inflection point in the group.
Archie Foster,
Product Manager — CIR Americas
Your comments and suggestions are welcome; please email USPortStrat@Citi.com Citi Investment Research: Key Data & Forecasts
Key Indices
Performance % 7/22/08 DJIA S&P 500 S&P MidCap 400 Nasdaq Comp. Russell 2000 Global MSCI 11,603 1,277 816 2,304 717 1,378 Week 5.8% 5.1% 5.6% 4.0% 8.2% 4.0% 12-Mo -16.2% -16.8% -10.7% -14.3% -14.3% -16.1% YTD -12.5% -13.0% -4.9% -13.1% -6.4% -13.3% 750 4.6% CIR Frcst Y/E 2008 13,950 1,550 850 Implied Upside 20.2% 21.4% 4.1% Real GDP (Y/Y % Chg) CPI (Y/Y % Chg) Fed Funds (%, End of Period) 10-Yr Treasury (%, Period Avg) S&P 500 Oper EPS ($/Shr) S&P 500 Oper EPS (Y/Y %) S&P 500 Dividends ($/Shr) S&P 500 Div. P/O Ratio (%) 2.00% 4.08% 7/22/08 4Q 2007 2.50% 4.00% 4.25% 4.26% $16.04 -28.5% $7.66 47.76% 2006 2.90% 3.20% 5.25% 4.79% $88.08 15.5% $24.88 28.1% 2007 2.20% 2.90% 4.25% 4.63% $84.46 -4.1% $27.73 32.8%
Key Economic Data
CIR Forecast 2008 1.60% 4.20% 2.00% 3.93% $85.50 1.2% $29.12 34.1% CIR Forecast 2009 1.40% 2.70% 3.00% 4.35% $90.00 5.3% $30.57 34.0%
Commodities
Performance % 7/22/08 Gold $/Troy Oz Crude Oil $/Bbl* *WTI $957.80 $127.95 Week -2.9% -7.8% 12-Mo 40.3% 69.3% YTD 51.0% 109.5% CIR Frcst 2008 Avg $905.48 $116.96 Implied Upside -5.5% -8.6%
FX Rates
Performance % 7/22/08 USD/EUR USD/GBP JPY/USD 1.57840 1.9909 107.36 Week -0.8% -0.7% 2.6% 12-Mo 14.2% -3.2% -11.5% YTD 8.2% 0.3% -3.6% CIR Forecast 2008 Avg 1.58 1.93 102.66 Implied Upside 0.1% -2.9% -4.4%
Source: Citi Investment Research
US082693
2
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Macro / Commentary
U.S. Equity Strategy
This article is an excerpt from our July 18, 2008, note (see extended version for details). Smith Barney Financial Advisors should call 212-816-1580 with questions.
The Certainty of Uncertainty While Ignoring Reality
Tobias M. Levkovich Unknowns exist in other sectors too. There is deep and probably appropriate worry about financial companies’ holdings of various exotic securities and their worth. Yet, one could easily argue that values attributed to thus far untested and unapproved drugs for pharmaceutical and biotech firms or the actual existence and value of natural resource reserves for mining or energy entities have very similar uncertainties. However, they are not priced accordingly given existing fear levels in the financial arena and potentially unfounded hope for continued global growth in the face of weakening economic trends worldwide. Commodity weakness now is different than in January and March. One could have argued that the prior trades out of commodities and energy earlier this year were sentiment based, but that economic conditions were still solid. There are four key differences now: slumping U.S. industrial activity, weaker earnings guidance, news of European economic woes, and stretched oil prices when considering historical relationships. Global growth does not mean that cycles have ended. Secular growth from developing economies will alter the slope of the long-term trend line demand for commodities and energy resources as well as related extraction equipment, but it does not change the impact of business cycles on shorterterm product requirement and prices thereof. Thus, our Capital Goods and Materials underweight stances remain intact, as does our Energy underweight position.
In the Midst of a Turning Point
Some rather startling stock market moves occurred in the past week or so, with the scare around GSEs and the IndyMac takeover causing a major sell-off in Financials sector stocks, followed by aggressive government intervention to generate stability. In addition, a break in energy prices provided some relief, causing at least a partial unwind to the “long energy/short financials” trade that many momentum-driven investors have had on since the latter part of 2007. To be fair, there have been a few such false dawns before, especially in January and March of this year, making many investors suspicious of the current volatility, but there are a number of critical differences now. 1. The move in oil prices relative to stocks was overly stretched. As we have noted in several reports during the past few weeks, the move in oil prices relative to the S&P 500 Index has gone to very extended levels seen only five times in the past 36 years. All were very short in duration, other than the period of the Arab oil embargo in 1973–74, and another energy supply shock (which is not being forecast as a base case by the vast majority of investors) would be necessary to replicate that trend. After the 1979–80 energy price spike, tied to the fall of the Shah of Iran and the ensuing American hostage crisis, the S&P 500 climbed 22.9% higher in the
3
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
next six months, and the same thing occurred following the 1990 invasion of the Kuwait-related oil price increase, when stocks jumped 22.6%. The 2000– 01 energy price outperformance was a result of oil prices doubling from their low levels of about $10/barrel; the S&P 500 did climb 11.1% in the subsequent six months, but that also led to the bursting of the tech bubble. The surge in energy in the past year has reflected global growth, the dollar’s weakness, lower inventory, equity market woes and alternative investment money flows. Yet, two standard deviation–plus events are rare and, arguably, unsustainable, especially as fuel demand destruction reportedly has begun. 2. Business trends are slipping three quarters after credit conditions unraveled. We have stressed since October that credit conditions lead industrial production and capital investment by three quarters. Credit problems began last August and have deteriorated since, putting more pressure on future capex trends, starting in June of 2008 and likely carrying into 2009. Auto production cuts in 2H08 also should pull down demand from suppliers to that industry, and they are not alone, with chemical companies idling plants and some equipment companies announcing worker layoffs. In addition, we have heard that steel companies have tried to raise prices and such attempts have been shot down by auto customers, who are trimming back production of larger vehicles. This makes the nearer-term cyclical environment less supportive of the secular demand story from developing regions. Indeed, coal stocks have also fallen based on this development, since metallurgical coal is used for coking ovens to produce steel and thus are a derivative of changes in industrial trends. Interestingly, industrial companies are also the biggest customers of electric utilities that burn coal and, hence, any slowing in industrial trends also affects utilities in ways that are not well understood. For instance, the chemical industry accounts for near 10% of all U.S. electric demand. 3. Industrial and capital spending–sensitive companies guiding down 2H EPS. In June, companies such as Rockwell, Oshkosh Truck, and UPS indicated that things were slowing down, with earnings guidance being lowered. This was followed by Eaton, Nucor, and Textron recently, and we have heard words of caution from tech giants Cisco Systems and Microsoft as well. And, while Terex has not yet guided the Street on earnings, announced layoffs hint at some pressures. Essentially, capital spending–driven businesses are faced with higher weighted average costs of capital from tighter credit conditions and are thus acting accordingly by delaying or scrapping projects whose returns cannot reach higher hurdle rates causing estimates to be trimmed (see Figure 1). Interestingly, Marriott noted in its quarterly earnings conference call that tighter financing was a problem in the U.S., Europe, and Latin America, but not an issue in Asia or the Middle East. In particular, smaller franchisees appear to be facing major challenges in procuring credit. In this context, bank loan standards are extremely tight for small businesses and, thus, the small business sector, in particular, is very unenthusiastic about its future (see Figure 2). Consequently, it is less likely to spend money aggressively.
Figure 1. S&P 500 Capital Goods: Upward Revisions as a % of Total vs. Performance
100% 90% 80% 70% Revisions 60% 50% 40% 30% 20% 10% 0% 1/31/97 7/31/97 1/30/98 7/31/98 1/29/99 7/30/99 1/31/00 7/31/00 1/31/01 7/31/01 1/31/02 7/31/02 1/31/03 7/31/03 1/30/04 7/30/04 1/31/05 7/29/05 1/31/06 7/31/06 1/31/07 7/31/07 1/31/08 7/17/08 400 300 600 500 800 Performance 700 1000 900
Upward Revisions
Current Constituents Performance
Source: FactSet and Citi Investment Research – U.S. Equity Strategy
Figure 2. NFIB Small Business Optimism Index
120
115
110
105
100
95 Jan-86 Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08
Source: Haver Analytics
4
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
4. International weakness gathering steam. Part of the business weakness is global, with European business conditions suffering from the change in credit availability and higher energy prices too. Business confidence has fallen sharply (see Figure 3) amid weak retail sales, soft housing markets, bank woes, pummeled equity markets, and a strong currency affecting exports. Indeed, we highlighted these concerns in our May 19, 2008 “Eye on Europe” report. Moreover, there are some initial indications of meaningful slowing in developing regions’ economic developments as a result of U.S. and European sluggishness, not to mention high energy and commodity prices. These four factors were not evident in January or March, when we saw sentiment shifts around commodities and energy, but they are becoming increasingly apparent now. As we noted in our March 20, 2008, Monday Morning Musings, "The Case for Crumbing Commodities," we thought that many of the risks would come to a head around mid-2008. In the past, weaker industrial activity was a clear signal for stock price problems in Capital Goods and Materials stocks, and we see little reason to believe much has changed, especially given more problems overseas. Although stock prices are down, the crowded global growth trades could unwind more if earnings estimates get cut further, as we deem likely. Note that tech-related capital spending is also affected and the likelihood for more job cuts is not good news for tech spending. As a result, we remain wary of this area of the market and see only semiconductor stocks as beneficiaries of this trend, since capex restraint may mean better pricing down the road as capacity utilization at fabs climb. Indeed, semi equipment orders in June dropped nearly 36% year over year, and such weakness has generally been associated with chip stock relative price strength. We fully understand that investors feel uncomfortable about buying financial names given their concerns about business models and the extent of the exposures on a wide variety of credit instruments. Yet, we must admit to being confused by this worry since there is a fair amount of uncertainty across a much wider variety of stocks and industries. Could a possible breakup of a legal cartel in fertilizer stocks crush parabolic stock price increases as farm states’ representatives get earfuls from constituents about escalating input costs? Moreover, do investors really know the accuracy of reserves stated by mining or energy companies? Furthermore, seismological or geological studies do not guarantee that extraction attempts will yield results. Many promising drugs do not get through Phase I, II, or III trials, but stock prices can become elevated on the hope that they work. Yet, there seems to be only certain uncertainty being ascribed to the Financials sector, and the reason, in our view, is news flow plus headlines, which create bias and not a dispassionate review of facts. The reality of credit affecting the costs of business investment with lag effects is ignored. Yet, the perception of open-ended risk in Financials and never-ending opportunity in natural resources and related extraction equipment is primarily due to investor prejudice, in our view. With news flow changing as a few financial firms put up respectable numbers and disappointment grows in the secular growth stories as earnings miss quarterly or full year estimates, we suspect that something more fundamental
Figure 3. Germany: ZEW Econ Sentiment, Macroeconomic Expectations [Next 6 Mos] (NSA, %)
100 80 60 40 20 0 -20 -40 -60 -80 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07
Germany: ZEW Econ Sentiment, Macroeconomic Expectations [Next 6 Mos] (NSA, %)
Source: Haver Analytics
5
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
is occurring. There is little doubt that three billion new global consumers are competing for the raw materials needed to improve their lives in order to emulate developed economy lifestyles. That argues for a change in the longterm trend demand, although it does not remove cyclical risk around the steeper sloped trend line. In many respects, this construct has been our chief quibble with the global growth thesis, beyond our long-held suspicion of the decoupling argument. As demand for commodities and energy in Europe and the U.S. falls and developing regions slow down, the near-term imbalances of supply and demand caused by that kind of shift can leave stocks priced for better news than companies can actually deliver. Since, the market is currently dominated by short-term traders, one can have a three- to five-year supercycle mindset, but carry inordinate equity risk in three to five days that can affect a portfolio meaningfully. One just needs to consider the swings in financial stocks and energy names in the past few trading days to understand the impact and the pain of being on the wrong side of the trade. While most investors, including us, have doubts that the Financials sector can continue moving directionally higher after its extraordinarily sharp bounce (obviously helped along by short covering), one piece of evidence suggests that there is potential for more near-term gains — our Cyclical Expectations Model (CEM, see Figure 4). The CEM usually leads market trading trends by one to three weeks, and Financials are a key element of the market. While the incessant banking woes damaged this relationship since June, it may be ready to get back on its six-year track. Accordingly, we are not backing off our Financials sector overweight, particularly given valuation attraction, beatendown earnings expectations, and still-awful sentiment. Indeed, disbelief in any kind of sustained run in the financial stocks is probably the most powerful investor emotion right now. Figure 4. Cyclical Expectations Model
1.20 1.00 0.80 0.60 0.40 CEM Model 0.20 0.00 -0.20 -0.40 -0.60 -0.80 -1.00 1/04/02 3/28/02 6/21/02 9/13/02 12/06/02 02/28/03 05/23/03 08/15/03 11/07/03 01/30/04 04/23/04 07/16/04 10/08/04 12/31/04 03/25/05 06/17/05 09/09/05 12/02/05 02/24/06 05/19/06 08/11/06 11/03/06 01/26/07 04/20/07 07/13/07 10/05/07 12/28/07 03/21/08 06/13/08
Source: Citi Investment Research – U.S. Equity Strategy
6
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Index Targets and Portfolio Weighting
2008 Targets: DJIA — 13,950
Actual Weight (% of S&P 500) 8.6% 0.5% 1.0% 1.5% 2.9% 2.7% 12.0% 3.5% 6.0% 2.5% 13.9% 13.9% 15.0% 2.8% 7.6% 3.4% 1.3% 12.1% 4.1% 8.0% 11.2% 8.6% 0.5% 2.1% 16.8% 2.4% 7.1% 7.3% 3.7% 3.7% 3.1% 3.1% 3.7% 3.7% CIR Rating + 0 0 0 + 0 0 + + + + + + + 0 + + 0 + + -
S&P 500 — 1,550
Sector
Industry Group
Rec'd Weight 9.1% 0.4% 1.0% 1.5% 2.9% 3.3% 11.5% 3.0% 6.0% 2.5% 11.4% 11.4% 17.6% 3.4% 9.1% 4.1% 1.0% 14.6% 4.9% 9.7% 10.1% 7.0% 0.5% 2.6% 15.9% 2.9% 7.1% 5.9% 3.0% 3.0% 3.7% 3.7% 3.1% 3.1%
Citigroup Strategist's Rationale Challenges on business fundamentals remain; unattractive valuation. Unattractive valuation; EPS estimate revisions have upside potential, still cautious towards homebuilders. Neutral valuation; slowing corporate profit growth negative for Hotels; overall revisions trends appeared to have bottomed. Attractive valuation; neutral EPS estimate revisions; seen as deeply challenged group. Attractive valuation; EPS estimate revisions rising, high short interest and out-of-favor group. Unattractive valuation, high short interest, earnings revisions could be headed lower. Unattractive valuation; group typically outperforms during post-bubble trading pullbacks. Usually outperforms during pullbacks and typically outperforms in the second half of the year; valuation still unattractive. Valuation is negative; earnings revisions trends are neutral; proprietary economic model suggests risk to these names. EPS estimate revisions seem to have troughed; most out-of-favor group with sell-side analysts. Spike in short interest; attractive valuation; EPS revisions trends may be troughing. EPS estimate revisions trends are near a bottom; valuation appears attractive; short interest is at all-time high. Valuation still unattractive, less dividend yield appeal, fundamentally challenged group. Valuation positive; group tends to outperform during post-bubble trading pullbacks. Valuation is attractive and proprietary economic model is generating a buy signal. EPS estimate revisions look risky; worrisome valuation, weakening ISM readings are a negative for this group. Positive valuation, but slowing economy would not benefit the group. EPS estimate revisions have bottomed; valuation is favorable. Semi indicator remains favorable, sentiment is positive. Positive valuation offset by a deteriorating fundamental backdrop. Risky earnings revision trends; negative valuation; softening capex environment. Unattractive valuation; commodity price concerns; weaker ISM readings could be a negative for the group. Appealing valuation; attractive dividend yield, earnings revisions trends could improve. Unattractive valuation and poor fundamentals. S&P weightings as of 7/22/2008
Consumer Discretionary Autos & Components Consumer Durables & Apparel Consumer Services Media Retailing Consumer Staples Food & Staples Retailing Food Beverage & Tobacco Household & Personal Products Energy Energy Financials Banks Diversified Financials Insurance Real Estate Healthcare Healthcare Equipment & Services Pharmaceuticals & Biotechnology Industrials Capital Goods Commercial Services & Supplies Transportation Information Technology Semiconductors & Semi Equipment Software & Services Technology Hardware & Equipment Materials Materials Telecom Services Telecom Services Utilities Utilities Legend: + = Overweight 0 = Market Weight - = Underweight
7
Citigroup Global Markets Equity Research
Source: Citi Investment Research U.S. Equity Strategy
US Portfolio Strategist 24 July 2008
Citi Investment Research Recommended List
YTD Through July 22, 2008 -13.03% -12.03% -13.55% -12.77% 1.01 Statistical Overview Perf. Price Since 07/22/08 Added $27.81 $14.24 $36.34 $38.75 $20.95 $52.05 $43.78 $77.00 $38.67 $220.92 $22.85 $45.61 $53.83 $72.25 $31.33 $36.16 $52.03 $48.63 $22.09 $21.90 $67.57 $34.68 $77.38 -31.64 % -23.89 % 16.92 % 5.38 % 1.75 % 4.46 % -11.34 % 59.90 % -22.02 % 27.38 % 118.66 % -11.42 % 5.90 % 21.55 % -15.23 % -18.74 % -11.53 % 9.77 % 7.34 % -7.98 % -1.01 % -3.26 % 11.03 % Analyst Ratings, Targets & Estimates Mkt Cap (mil) $9,783 $37,243 $15,508 $55,370 $10,215 $109,768 $31,215 $63,196 $42,880 $25,722 $26,178 $25,268 $38,189 $31,479 $67,251 $17,530 $15,891 $7,966 $126,399 $129,473 $5,146 $98,860 $23,588 2008 Perf. YTD -18.64% -30.50% -8.07% -2.52% -11.94% #N/A -28.06% 0.01% -27.19% 1.90% -10.57% -12.67% -12.64% 56.35% -46.09% -37.36% -19.01% -12.36% -17.14% -19.10% 10.61% -20.27% 6.97% Fiscal Year End Dec Jun Dec Dec May Dec Dec Dec Nov Dec Dec Dec Dec Dec Dec Dec Dec Dec Dec Jul Dec Dec Dec Price Target $37.00 $26.00 $55.00 $52.00 $32.00 $62.00 EPS Estimates Next Cur. $1.83 $1.39 $2.60 $2.95 $1.80 $3.77 $8.06 $10.98 $6.00 $10.15 $1.35 $6.50 $7.25 $2.32 $3.79 $4.50 $3.14 $4.20 $1.61 $1.70 $5.77 $3.02 $5.00 $1.78 $1.17 $2.18 $2.50 $1.60 $3.32 $6.66 $10.33 $4.00 $8.70 $1.07 $6.06 $6.30 $1.51 $3.34 $4.00 $2.61 $3.40 $1.30 $1.52 $5.38 $2.60 $4.30 P/E Next Cur. 15.2 10.3 14.0 13.2 11.7 13.8 5.4 7.0 6.4 21.8 16.9 7.0 7.4 31.2 8.3 8.0 16.6 11.6 13.7 12.9 11.7 11.5 15.5 15.6 12.2 16.7 15.5 13.1 15.7 6.6 7.5 9.7 25.4 21.4 7.5 8.5 47.9 9.4 9.0 19.9 14.3 16.9 14.4 12.6 13.4 18.0 5-Year Beta 1.21 1.03 0.63 0.67 0.61 0.50 1.17 0.97 1.70 1.30 1.68 0.75 1.12 0.95 0.46 0.74 0.84 1.17 1.49 1.17 1.04 0.97 0.65 Attributes Div. Yield Drivers, Fundamentals & Valuation 1.3% Attractive valuation, strong cyclical growth, global brand penetration opportunities 0.8% Strong earnings visibility, a Sky Italia IPO - potential catalyst 2.2% 0.7% 3.6% 3.5% Dividend, restructuring story, China operations Poised to benefit from both industry and company-specific opportunities. Restructuring story, defensive hedge, dividend Growth, predictability, high cash flow yield and low litigation risk 2007 3.53% 5.49% 8.59% 10.13% 2006 13.62% 15.79% 14.99% 16.50% 2005 3.00% 4.90% 14.01% 15.29% 2004 8.99% 10.88% 24.14% 25.92% 2003 26.38% 28.68% Recent Changes: *KSS and NKE were added; MRO, AGN, and NWS.A were removed 7/23/08 after the close, see call note for details (These changes will be incorporated into next week's table.) *MRK was added on 7/17/08 after the close, see call note for details Rec List changes are announced via a call note posted on GEO, SB Linx and other internal research systems; we do not maintain 43.01% an email list announcing changes; FA's with questions, please contact the Research Service Center at 212-816-1580. 44.85%
S&P 500 Performance S&P 500 Total Return Recommended List Index Equal Weighted Performance Recommended List Index Equal Weighted Total Return Recommended List Portfolio Beta
Date Added CONSUMER DISCRETIONARY Marriott International (MAR) 10/15/2007 News Corp. (NWS.A) 7/14/2006 CONSUMER STAPLES Avon Products (AVP) 4/13/2006 CVS Caremark Corp (CVS) 1/11/2008 Conagra (CAG) 1/4/2006 Philip Morris Intl. (PM) 6/27/2008 ENERGY Marathon Oil (MRO) 2/8/2008 Occidental Petroleum (OXY) 4/13/2006 FINANCIALS Morgan Stanley (MS) 1/29/2008 BlackRock (BLK) 2/8/2007 Charles Schwab Corp. (SCHW) 4/1/2005 Allstate Corp (ALL) 1/11/2008 MetLife (MET) 1/4/2006 HEALTH CARE Celgene Corp (CELG) 3/28/2008 Merck (MRK) 7/17/2008 Aetna Inc (AET) 6/13/2008 Allergan (AGN) 1/18/2007 INFORMATION TECHNOLOGY Fiserv (FISV) 1/4/2006 Intel (INTC) 11/10/2006 Cisco Systems (CSCO) 2/25/2008 MATERIALS Eastman Chemical Co (EMN) 7/30/2007 Telecom Services Verizon (VZ) 3/28/2008 Utilities FirstEnergy Corp (FE) 1/29/2008
Price Added $40.68 $18.71 $31.08 $36.77 $20.59 $49.83 $49.38 $48.16 $49.59 $173.44 $10.45 $51.49 $50.83 $59.44 $36.96 $44.50 $58.81 $44.30 $20.58 $23.80 $68.26 $35.85 $69.69
Rating 1M 1M 1M 1M 1M 1M
8
1H $74.00 1M $116.00 1M $65.00 1M $240.00 1M $27.00 1M $56.50 1L $70.00 1H 1M 1H 2M 1M 1M 1M 1M 1H 1M $79.00 $42.00 $52.00 $54.00 $67.00 $26.00 $31.00 $84.00 $42.00 $86.00
2.2% Combination of value, growth and operational catalysts 1.7% Profitability, buybacks, production growth 2.8% 1.4% 0.9% 3.6% 1.4% 0.0% 4.9% 0.1% 0.4% Underestimated earnings power, mortgage and CDO issues behind the firm Positioned to capitalize on global growth, strong EPS potential Rising equity market expected, strong upside earnings leverage Compelling valuation, better-than-peer premium growth Strong business fundamentals and ROE Promising pipeline, market leading products in blood cancer, operating leverage Above average revenue and earnings growth; undervalued new product cycle Good cash flow; several potential acquisition candidates New aesthetic products, Botox growth, and operating leverage
Citigroup Global Markets Equity Research
0.0% Attractive valuation, potential financial restructuring 2.5% Expect upward EPS estimate revisions, renewed product portfolio 0.0% Attractive valuation, reasonable consensus expectations 2.6% Continued upside from new product launches and base businesses 5.0% Stable revenue growth, earnings power should accelerate heading into 2009 2.8% Attractive valuation, significant earnings growth potential
Note: Portfolio performance based on daily index level as calculated by S&P/Citigroup Global indices; index performance incorporates historical constituent changes and is measured using daily close prices. Price added is prior day's close when stock is added b/f market open. Price added is same day close when stock is added after market open. Methodology generally mirrors that used to calculate the S&P equal weighted index. No transaction costs are assumed. Past performance not indicative of future performance. Added companies: Kohl's Corp. (KSS.N; US$42.91; 1H), Nike Inc. (NKE.N; US$58.67; 1L) Source: Citi Investment Research U.S. Equity Strategy, S&P Global Indices, and FactSet
US Portfolio Strategist 24 July 2008
Macro / Commentary
Small & Mid-Cap Strategy
This article is a summary of our report, "SMID Bit: A Faint Drumroll for Deal Activity, Early Earnings Takeaways," July 21, 2008. For more details, including initial takeaways from the current reporting season, please see the full version at the following link: https://www.citigroupgeo.com/pdf/SNA22 101.pdf
A Faint Drumroll for Deal Activity
Lori Calvasina Key Takeaway — Challenging economic and financing conditions remain key headwinds for U.S. M&A. However, small cap price/book and price/sales – which have been closely correlated with deal trends — are at 1.9x and 1.1x, respectively, close to the levels that marked the last bottom in U.S. M&A activity. M&A seems to be a distant, but growing, bright spot in the small/micro cap outlook. Valuation Has Mattered Lately in M&A — Over the past several weeks, few takeover announcements have centered on the “new growth” commoditybased sectors, which are unattractive on our valuation work. Nearly 2/3’s of M&A announcements over the past month for U.S. companies trading on major exchanges have come from Technology, Consumer Discretionary, and Health Care, sectors that appear attractive on our valuation analysis. Earnings and short covering were the primary points of discussion among equity investors last week, as the SEC announced new/amended rules regarding short selling, and quarterly earnings reports started to trickle in. Through it all, a handful M&A announcements managed to grab a few headlines.
M&A
Figure 1. Quarterly Real U.S. GDP Growth vs. U.S. M&A Deals (Year-Over-Year Percent Change)
9 8 6 Real GDP 5 3 2 0 -2 -3 1Q91 2Q92 3Q93 4Q94 1Q96 2Q97 3Q98 4Q99 1Q01 2Q02 3Q03 4Q04 1Q06 2Q07 40 30 20 10 0 -10 -20 -30 -40
Real Gross Domestic Product (SAAR, %Chg)
Yr/Yr % Change US M&A # of Deals
We think it is still too early to assume that the market is out of woods near term. Evolving SEC rules on short selling also remain a wild card for the time being. But beyond our near-term concerns, recent trends in M&A are encouraging — one of the few potential (though still distant) bright spots in the small and micro cap outlook.
Source: Citi Investment Research Small/Mid Cap U.S. Equity Strategy, SDC; quarterly through 2Q08 (M&A) and 1Q08 (GDP)
Economy a Challenge, but Valuations Suggest Improving M&A Trends Not Out of the Question
There are two conditions that we have found to be highly correlated with U.S. M&A activity – economic trends and small cap valuation levels. Regarding the first condition, M&A declines have tended to occur during difficult economic times, while deal recovery has tended to take place alongside a reacceleration in GDP. We have contended in the past that deal trends are likely to improve once the economy stabilizes and confidence returns to the market place. For the time being, the economy, market confidence, and, as a result, financing conditions still seem to be headwinds. However, the second condition – valuation – does seem to be more supportive of an improvement in deal trends. Small cap valuations (specifically price/book and price/sales) and U.S. M&A deal numbers have been closely correlated over time. Although these metrics are not yet at the levels seen at the broader market bottom following the collapse of the Internet bubble, they are within a whisper of the levels that coincided with the bottom of the last M&A cycle. Price/book for the Russell 2000 currently stands at 1.9x, a hair above the 1.8x level that preceded the M&A bottom in the Fall of 2001. Price/sales for the Russell 2000 stands at 1.1x, slightly above the 1.0x level seen in the fall 2001.
Figure 2. Small Cap Price/Book vs. U.S. M&A Trends
3.5 3.0 2.5 price/book 2.0 1.5 1.0 0.5 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 correlation = 0.78 1,600 1,400 1,200 # deals 1,000 800 600 400 200
# US M&A Deals
R2000 Price/Book
Source: Citi Investment Research Small/Mid Cap U.S. Equity Strategy, BNY Mellon
9
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Figure 3. Small Cap Price/Sales vs. U.S. M&A Trends
1.8 1.6 1.4 1.2 price/sales 1.0 0.8 0.6 0.4 0.2 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 400 200 1,200 # deals 1,000 800 600 correlation = 0.88 1,600 1,400
Our bottom line - Although the economy, confidence, and financing conditions continue to serve as a headwind to M&A, small cap valuations suggest we should be on the lookout for at least some improvement in deal trends.
Attractively Valued “Old Growth” Sectors Seeing the Most Activity
Importantly, it appears that recent U.S. acquisition announcements may be motivated by bargain hunting. Nearly two thirds of recent acquisition announcements for U.S. companies trading on major U.S. exchanges have come out of the “old growth” sectors of Health Care, Technology, and Consumer Discretionary. As we highlighted in our recent Small and Mid Cap Sector Snapshot reports, each of these sectors appears to be attractively valued. Pharma & Biotech, Semis & Semi Equipment, and Application Software have been some of the most popular industries for M&A within these sectors. By contrast, we count only three transactions that have been announced in momentum areas like Agriculture Products, Coal, or Oil & Gas E&P over the past month. Our work on sector valuations indicates that small/mid cap Energy and Materials remain unattractive and recently hit new extremes.
# US M&A Deals
R2000 Price/Sales
Source: Citi Investment Research Small/Mid Cap U.S. Equity Strategy, BNY Mellon
Figure 4. European Cross Border M&A Activity as a Percent of Total Global M&A (Number of Deals)
10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% January 1995 January 1996 January 1997 January 1998 January 1999 January 2000 January 2001 January 2002 January 2003 January 2004 January 2005 January 2006 January 2007 January 2008
Small/Micro Cap Advantage?
Importantly, the bulk of announced M&A transactions in recent weeks have been for stocks trading under $1 billion market cap at the time the deal was announced. We suspect that as long as financing conditions remain tight, smaller deals are more likely to get done than mid and large sized ones — a dynamic that may continue to benefit small and micro caps. Also, many smaller cap names are hitting intriguing levels when we look at cash to market cap. We recently screened the Russell 2000 for stocks that have more than 20% of their market cap available in cash, plus net debt to cap levels below 20%. When we excluded the Financials sector, 230 stocks passed our screen. For a list of stocks in our screen, please see the full version of this report.
Europe/Asia-Pac + Aust/NZ
Europe/Latin America
US/Europe
Source: Citi Investment Research Small/Mid Cap U.S. Equity Strategy, SDC
Emerging Markets Weakness May Encourage Bargain Hunting at Home
Only a handful of U.S. M&A deals announced over the past few months have been cross-border transactions, and these have mainly been limited to larger sized deals. To be clear, we are not overly optimistic about a surge in cross border M&A transactions infiltrating the U.S. equity market just yet. We continue to believe some significant strengthening of the U.S. dollar may be required to convince European strategic buyers that “now” is the time to take advantage of a weak U.S. currency. Moreover, we would also not be surprised to see mounting economic problems in Europe restrain acquisition appetites. But deterioration in emerging markets’ economies (which seems likely to mount as inflation pressures surge) may encourage U.S. companies to start bargain hunting at home. Even though European cross border deal trends have continued to gravitate towards the Asia-Pacific region (most of which we presume is to emerging markets) and Latin America, the U.S./Asia-Pacific share of global M&A activity has slowed dramatically since late 2007. Much of this decline has likely been driven by the collapse of private equity activity and a lack of economic confidence and tougher financing conditions within the U.S. But it seems noteworthy that deals involving U.S. companies have not revolved around emerging markets for the past several months.
Figure 5. U.S. Cross Border M&A Activity as a Percent of Total Global M&A (Number of Deals)
3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% January 1995 January 1996 January 1997 January 1998 January 1999 January 2000 January 2001 January 2002 January 2003 January 2004 January 2005 January 2006 January 2007 January 2008
US/Asia-Pac + Aust/NZ
US/Latin America
Source: Citi Investment Research Small/Mid Cap U.S. Equity Strategy, SDC
10
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
SMID Target List
7/22/2008 SMID Target List Portfolio Equal Weighted Performance Russell 2000 Performance S&P Mid Cap Performance Russell 2500 Performance 6/1/2007 to present -15.43% -16.01 -11.46 -18.14 6/1/2007 12/31/2007 -4.04% -10.24 -6.90 -9.68 2Q08 6.98% 1.48 5.62 1.84 3Q08 TD 2008 YTD -1.04% -11.88% 2.68 -6.42 -0.86 -4.90 -1.44 -9.37 Recent Changes: NYB Removal: Change to the SMD Target List index effective as of close 6/25/08 BJ Removal: Change to the SMD Target List index effective as of close 6/24/08 VRX Removal: Change to the SMID Target List index effective as of close 5/9/08. WWW Removal: Change to the SMID Target List index effective as of close 4/16/08. GET Removal: Change to the SMID Target List index effective as of close 4/16/08. Changes to this list are announced via a call note posted on GEO, SB Linx and other internal research systems; we do not maintain an email list announcing changes; Smith Barney Financial Consultants with questions, please contact the Research Service Center at 212816-1580. Opinion
Date Added Price Price To Index Added Cur. CONSUMER DISCRETIONARY BORGWARNER INC URBAN OUTFITTERS INC THQ INC CONSUMER STAPLES ALBERTO-CULVER CO UNITED NATURAL FOODS INC ENERGY FOREST OIL CORP FINANCIALS ARCH CAPITAL GROUP LTD ALEXANDRIA R E EQUITIES INC HEALTH CARE UNITED THERAPEUTICS CORP HEALTH NET INC VARIAN MEDICAL SYSTEMS INC INDUSTRIALS WASTE CONNECTIONS INC ROPER INDUSTRIES INC/DE INFORMATION TECHNOLOGY AMPHENOL CORP ON SEMICONDUCTOR CORP EQUINIX INC IHS INC MATERIALS PACTIV CORP TELECOM TW TELECOM INC UTILITIES WISCONSIN ENERGY CORP BWA 6/1/07 URBN 10/31/07 THQI 4/8/08 ACV UNFI FST ACGL ARE UTHR HNT VAR WCN ROP APH ONNN EQIX IHS PTV TWTC WEC 1/22/08 3/25/08 6/1/07 6/1/07 3/12/08 1/22/08 1/22/08 3/25/08 6/1/07 7/13/07 8/1/07 6/1/07 6/1/07 2/8/08 3/25/08 12/3/07 6/1/07
Statistical Overview Perf. Mkt 2008 52 Wk Since Cap TD Div. Beta Added (mil) Perf. Yield (NYSE) $4,944 $5,443 $1,194 $2,553 $780 $5,432 $4,367 $3,312 $2,363 $2,698 $6,584 $2,265 $5,692 $8,654 $3,575 $3,318 $3,933 $2,885 $2,191 $5,114 -12.04% 1.0% 19.59% 0.0% -36.15% 0.0% 3.34% 1.0% -42.65% 0.0% 20.57% 0.0% -3.98% 0.0% 2.86% 3.0% 7.63% 0.0% -47.93% 0.0% 0.58% 0.0% 10.39% 0.0% 1.79% 0.5% 6.43% 1.58% -10.71% 3.98% 0.1% 0.0% 0.0% 0.0%
CIR Ratings, Targets & Estimates Fiscal EPS Est Year Price Est. P/E P/E End Rtg Target Upside Next Cur. Next Cur. CIR Analyst 57.00 35.00 29.00 30.00 25.00 99.00 34% 7% 61% 18% 37% 62% 24% 17% 24% 31% 14% 20% 10% 11% 55% 33% 24% 36% 68% 17% 3.34 2.93 12.8 14.5 Itay Michaeli 1.20 0.94 27.2 34.5 Kimberly Greenberger, CFA 1.10 -0.20 16.4 -91.1 Brent Thill 1.41 1.25 18.0 20.3 Wendy Nicholson 1.40 1.12 13.0 16.2 Gregory R Badishkanian 4.51 5.73 13.6 10.7 Gil Yang 9.35 10.00 7.2 6.8 Joshua Shanker 3.32 2.81 31.5 37.2 Michael Bilerman 2.85 1.55 36.9 67.8 Lucy Lu, MD 3.40 3.00 7.4 8.4 Charles Boorady 2.36 2.10 22.2 25.0 Amit Bhalla 1.82 1.57 18.7 21.8 Leone T Young 3.65 3.18 17.5 20.0 Jeffrey T Sprague, CFA 2.64 1.05 3.21 2.37 2.39 18.7 20.7 Jim Suva, CPA 0.78 8.6 11.6 Craig A Ellis 1.07 28.1 84.7 Michael Rollins, CFA 1.92 26.6 32.8 Patrick M Burton, CFA
Thesis Market leading fuel efficiency and emissions technology; takeout candidate Same store sales acceleration, differentiated product, square footage growth potential Industry less sensitive to economic turndown, upcoming games in 2009, M&A potential Defensive industry, EPS growth/cost savings from restructuring, strong organic growth Gaining market share in rapidly growing natural food industry; valuation attractive Streamlined operations; improving natural gas portfolio Summer trade up in group; underappreciated stock; potential EPS upside Niche product, strong demand expected despite patent expirations, R&D focused Defensive sector, Viveta FDA approval likely, takeover potential Defensive sector, strong Medicare Advantage and Part D enrollment growth Focus on oncology, continued product demand Pricing power, defensive Strong growth; FCF and margins; benefits from private equity selling International sales exposure, above industry average sales growth Upward EPS estimate revision potential Favorable demand and pricing; leveraged to voice and internet trends Unmatched market postition, strong balance sheet, solid free cash flow capabilites May benefit from potential commodity price declines and recent merger integration Defensive, niche position, strong facilities based fiber assets, sustainable revenue growth Attractive dividend yield; superior EPS growth & valuation vs. peers
41.83 42.58 1.81% 25.27 32.60 29.01% 22.74 18.00 -20.84% 24.16 25.36 17.84 18.19 4.97% 1.96%
1.4 Dec-08 1M 1.7 Jan-08 1H 0.5 Mar-08 1S 0.6 Sep-08 1M 1.1 Jul-08 1H 0.7 Dec-08 1H
11
41.48 61.30 47.78% 71.68 67.55 -5.76% 89.57 104.58 16.76% 90.70 105.10 15.88% 47.89 25.15 -47.48% 48.02 52.46 9.25% 31.28 34.11 62.00 63.66 9.05% 2.68%
0.7 Dec-08 1M 84.00 1.1 Dec-08 1H 122.00 (0.4) Dec-08 1H 130.00 0.8 Dec-08 1H 33.00 0.9 Sep-08 1M 60.00 0.6 Dec-08 1M 1.0 Dec-08 1M 0.9 1.3 1.6 0.6 Dec-08 Dec-08 Dec-08 Nov-08 41.00 70.00
35.78 49.35 37.93% 10.81 9.02 -16.56% 86.54 90.25 4.29% 63.06 62.97 -0.14% 27.35 22.06 -19.34% 23.29 14.91 -35.98% 48.40 43.74 -9.63%
1M 55.00 1S 14.00 1S 120.00 1H 78.00 30.00 25.00 51.00
Citigroup Global Markets Equity Research
-17.16% 0.0% -26.52% 0.0% -10.20% 2.5%
1.3 Dec-08 1M 1.4 Dec-08 1S 0.5 Dec-08 1L
2.15 1.78 10.3 12.4 Timothy Thein, CFA 0.49 0.19 30.4 79.7 Erin E Schmitz, CFA 3.40 2.85 12.9 15.4 Greg Gordon, CFA
Note: Portfolio performance based on daily index level as calculated by S&P/Citigroup Global indices; index performance incorporates historical constituent changes and is measured using daily close prices. Past performance not indicative of future performance. Names are not listed in any particular order. Source: Citi Investment Research Small/Mid Cap US Equity Strategy, S&P Global Indices, and FactSet
US Portfolio Strategist 24 July 2008
US Portfolio Strategist
12
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Macro / Commentary
Economic & Market Analysis
Figure 1. U.S. Financial Operating Profits and S&P 500 Financial Operating Profits, millions of $
g
70000 60000 50000 40000 30000 20000 10000 0 -10000 -20000 1988
Last data point for NIA is 1Q 2008, S&P financials is blended actual and consensus for 2Q 2008
Take a Hint from Financials
Steven Wieting Bank share prices posted the largest one-year decline in the post-war period in the year through this past week — a drop of 67% in the year through Tuesday. The declines in the financial sector should rightly raise concerns about the real economy. Broad financial events tend to lead economic weakness. Financial earnings lead non-financial earnings. However, the higher degree of leverage in the financial system itself suggests a much more severe profit cycle there. Non-financial debt burdens don’t look as onerous as implied by high levels of “portfolio debt.” Still, the financial sector’s woes should be a warning even if it is the first to see a rebound from cyclical losses. The entire S&P 500 is not going to see a 6% EPS gain in 2008, as consensus projects.
S&P Financials, Operating Profit National Accounts (pre-tax profits from current production income)
Asset Writedowns of $70B in 4Q 2007 and $51B in 1Q 2008 2Q TBD
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
Source: Bureau of Economic Analysis (BEA), S&P, Factset, Bloomberg
Uncovered Stones
To say that the real economy will fare better than the financial sector is not saying much these days. As Figure 1 shows, an index of bank stock prices has fallen more over the past year than any period since at least World War II. The total market capitalization of the financial sector, about $1 trillion, doesn’t look like its recently reported profits: In 4Q 2007 and 1Q08, profits averaged nearly zero, with improvement on smaller mark-to-market losses apparent in both 1Q and 2Q, as partial results suggest. Still, the share of market capitalization represented by large-cap financial firms in the S&P 500 has roughly halved since early 2007. This is the largest drop relative to the broad stock market that we can identify (see Figure 1). Unlike the ubiquitous advertisements for Las Vegas tourism, what happens in financial markets doesn’t stay in financial markets. Profitability in the financial sector leads turns in profits in the real economy, as financial markets discount economic downturns generally before they occur. In particular, consider the effects of mark-to-market accounting: A large decline in the price of assets held for sale can determine financial profits as fast as markets can turn. Broadly speaking, such asset price declines are embedded predictions of the performance of the economy. And as we discussed last week, the banking sector itself also plays a role in determining the economic outlook through the ability and proclivity to lend.
6 5 4 3 2 1 0
Figure 2. Gross Outstanding Financial and Nonfinancial Debt vs. GDP (1990=100)
700 600 500 400 300 200 100 0 70 73 76 79 82 85 88 91 94 97 00 03 06
(
)
700 600 500 400 300 200 100 0
Financial
Nonfinancial
Nominal GDP
Source: Federal Reserve Board (FRB), BEA
Figure 3. Household Debt Payments and Nonfinancial Business Net Interest Costs as % of Income and Output
16 14 12 10 8 6 4 2 0 Household Debt Service Payments as % of Disposable Income (left) Net Interest Payments as % of Non-Financial Business Output (right)
1980
1983
1986
1989
1992
1995
1998
2001
2004
2007
Source: FRB, BEA
Like the period near the start of the 1990s, we don’t expect non-financial business to ultimately suffer profit declines to the same extent as the financial sector. Highly leveraged financial institutions naturally leverage both the upside and the downside. As Figure 2 shows, gross financial debt soared relative to non-financial debt in the past ten years. The net burden of financial obligations for consumers and business rose, but far less profoundly than gross financial debt (see Figure 3). Roughly $10 billion in missed mortgage interest payments by U.S. households last year wrecked havoc on markets and institutions that had borrowed many times over against income flows that proved less than perfect.
13
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Figure 4. Citi Financial Conditions Index (leading 6 months) and Real Consumer Spending Y/Y%
3σ 2 1 0 -1 -2 -3 -4 87 89 91
June '08 FCI, Apr/May PCE
p
g
6 % 5 4 3 2 1 0 -1 09
93 95 97 99 01 03 05 Financial Conditions (Lead 6-Mo., Left) Real Consumer Spending (Right)
07
More cautious lending and broadly higher capital costs will of course still be felt. Share prices across the world show few signs of decoupling across countries and markets. Similarly, just because financial firms have been the first to feel the negative effects of past excesses, it doesn’t mean those effects will be entirely contained to the financial sector itself. The deterioration in financial conditions is consistent with weaker consumer demand beyond the immediate period of strong tax stimulus (see Figure 4). Interestingly, demand hasn’t been impervious for products that have been in short supply, such as energy (see Figure 5). And as the consumer goes, so goes imports, resulting in the beginnings of an apparent slowing in trade and production data across the world (Figure 6). The notion that the consumer abroad is immune to budget shocks in food and energy or more difficult lending conditions is also quite suspect. Real retail sales have slowed almost proportionately across the developed world. To the extent data is available, it appears many foreign financial institutions have tightened lending standards in a way similar to U.S. institutions. The strength of lending data in both the U.S. and Europe has much to do, it seems, with credit commitments made before the latest banking turmoil, that will wane until or unless banking fundamentals make a recovery. In the U.S., yield curve steepening should at least make a contribution. Non-financial profits continue to grow from record levels. This is particularly true for U.S. profits earned abroad, which have leapt higher, but seem likely to face a deceleration. As history shows, such profits don’t grow without occasional interruption. The financial sector will never be the same, and it will take many tests and challenges to establish a recovery. But it has something to recover because so much has been lost. The string of record profitability in other areas seems likely to face challenges in due course, though likely of a lesser magnitude. Still, current estimates showing an acceleration in second half 2008 nonfinancial profits that seems implausible (Current estimates show a 16% EPS gain in 2H 2008 versus 9% in 1H 2008). The entire S&P 500 is not going to see a 6% gain in EPS in 2008, as current consensus shows. The 22% “bottom up” consensus EPS gain 2009 is even more implausible, and the implausibility of current estimates is probably the strongest consensus we’ve ever seen. Now here’s the question: Who is going to do the heavy lifting of cutting profit estimates down to reality?
Note: The Citi FCI is a composite measure of OAS corporate credit spreads, equity values, mortgage rates, money growth and retail energy prices expressed as standard deviations from mean readings. Source: BEA, Citi
Figure 5. Real Gasoline and Motor Fuel Sales, Y/Y % Change
12 9 6 3 0 -3 -6 -9 -12 54 57 60 63 66 69 72 75 78 81 84 87 90 93 96 99 02 05 08
Shaded areas depitct U.S. recessions.
OPEC 1
Gulf War Iran Revolution
Price Alone
Note: Last data point is April/May 2008 average Source: BEA, NBER, Citi
Figure 6. Manufacturing PMI Readings: U.S., Euro Area, U.K., Japan
65 60 55 50 45 40 35 1997 1999 2001 EURO 2003 UK US 2005 JPY 2007
Hey, It's Only the Developed World!
g
Last Data points are June '08
g
p
65 60 55 50 45 40 35
Source: ISM, Haver Analytics, Bloomberg
14
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Week-Ahead U.S. Economic Data Releases
Date 7/29 7/30 7/31 Time 10:00 8:15 8:30 Report Consumer Confidence (Jul) ADP Employment (Jul) GDP (2Q, Advance) GDP Price Index Employment Cost Index (2Q) 9:45 8/01 8:30 Chicago NAPM (Jul) Total Vehicle Sales (Jul) Nonfarm Payrolls (Jul) Unemployment Rate Average Hourly Earnings Average Weekly Hours 10:00 ISM Manufacturing (Jul) Prices Paid Construction Spending (Jun) Street Estimates 50.0 -48K 1.8% 2.7% 0.7% 49.0 13.9M -68K 5.6% 0.3% 33.7H 49.2 85.0 -0.3% Prior Report 50.4 -79K 1.0% 2.7% 0.7% 49.6 13.6M -62K 5.5% 0.3% 33.7H 50.2 91.5 -0.4%
Note: For detailed estimates, see the notes “Comments on Credit” by Bob Diclemente and “Forecast Supplement” by Peter D’Antonio. Source: Bloomberg
15
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
US Portfolio Strategist
16
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Charts of the Week
Steven Wieting
U.S. housing starts surged 9.1% in June to a 1.066 million unit pace. However, the entire rise was due to a 242% surge in multi-family starts in the northeast, which boosted the figure by 126,000 units (SAAR). New York City "building code changes," were responsible for the surge according to press reports. Singlefamily starts nationwide fell 5.3% after a 0.3% gain in May. More reliable singlefamily building permits showed a 3.5% drop in the month, in line with other fundamentals in homebuilding, including a new record low in floor traffic at homebuilders according to the July report from the NAHB. Notably, shopping for a home and obtaining credit are not closely related, and this suggests larger income and sentiment issues are at work.
1-Family Building Permits (Y/Y%) and NAHB Buyer Traffic
70 60 50 40 30 20 10 97 99 01 HMI Traffic (Left) 03 05 07 New Home Sales (R ight)
Last data point for June for Starts and July for HMI
30 20 10 0 -10 -20 -30 -40 -50
Source: Census Bureau and National Association of Homebuilders
30-Year Fixed-Rate Jumbo and Conforming Mortgage Rates
While the new home market has posted a larger downward correction than the resale market, inventories of new homes won't be cut sharply without an improvement in sales. In 2007, there was a brief period of stability in housing activity prior to the weakening in the mortgage finance industry. A new "down leg" in housing followed. Since then, mortgage rates have mostly risen in the face of weaker demand. Containing current pressures in mortgage availability would seem a requirement before there is an aggregate improvement in overall housing activity.
7.65 7.40 7.15 6.90 6.65 6.40 6.15 5.90 5.65 5.40 1/07 3/07 5/07 7/07 9/07 11/07 1/08 3/08 5/08 7/08 Jumbo (%, Left) Conforming (%, Left)
7.65 7.40 7.15 6.90 6.65 6.40 6.15 5.90 5.65 5.40
Source: Bankrate.com and Bloomberg
17
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
US Portfolio Strategist
18
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Macro / Commentary
Fixed Income Strategy
Figure 1. Two- and Ten-Year Yields and OptionAdjusted Spread, Jul 07-Jul 08
5.0 250 200 150 3.0 100 2.0 50 0 Jul-08 Basis Points
Reality Check
Michael Brandes / George Friedlander Safe haven sentiment continues to govern investor behavior as substantial transitions in the bond market persist. While the flight to quality reengaged last month (two- and ten-year Treasury yields declined by as much as 60bp and 40bp from mid-June peaks before retracing the gains), a number of headlines have complicated matters and prompted bond market participants to reassess the stability of quality holdings that have typically anchored diversified portfolios through difficult times. For instance, the federal government seizure of Indy Mac on July 14 shook investor confidence about the viability of FDIC-insured deposits and prospects for potential failures among other regional banks. While FDIC officials sought to reassure investors and immediately generated new rules to assist with the takeover of troubled banks in the future, the troubles at the regional banks are poised to continue as rising nonperforming assets strain balance sheets further. That said, FDIC will continue to be a strong regulator, and insured certificates of deposit within prescribed limits are not at risk, in our view. Against this backdrop, the unenviable tug of war between growth and inflation became more pronounced. With all the market headlines, investors may have missed Fed Chairman Bernanke’s comments last week that modified US economic risks from “diminished downside risks to growth” to increased risks to both growth and inflation. These twin forces are the bane of all central bankers — to be handcuffed by conditions that prevent both easing (to facilitate growth) and hiking short-term rates (to promote price stability). This is not simply a US phenomenon — continental European central bankers acknowledge similar constraints, while UK policymakers are faced with more extreme circumstances owing to their own credit crisis associated with a severe housing downturn.
4.0 Yield (%)
1.0 Jul-07
Sep-07 2-year
Nov-07
Jan-08 10-year
Mar-08
May-08
Spread (right)
Source: Citi
Market participants are worried that intervention could further bloat the federal budget deficit, necessitating greater Treasury supply just as tax revenues are poised to decline as a result of weakening economic prospects.
Complicating matters, the rally in government debt that typically occurs when safe haven sentiment rises reversed course in recent days owing to the expected costs associated with the rescue package being orchestrated for Fannie Mae and Freddie Mac (better-than-expected bank earnings, prompting an equity rally, lent an assist).
Finding Support for Fannie and Freddie
FNMA and FRE triple-A rated senior debt has provided long-standing, high-quality alternatives to Treasuries and investmentgrade corporate bonds, with yields that fall somewhere in between, depending on market conditions.
The uncertainties surrounding government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac are front and center. While the situation is clearly in flux, the proposed legislation put forth by Treasury Secretary Paulson has three key elements to support the GSEs: (1) increased credit lines with Treasury (currently at $2.25 billion each); (2) temporary authority (through December 2009) from Congress to allow Treasury to purchase unlimited equity stakes if necessary; and (3) giving the Federal Reserve a “consultative” role in a new regulatory framework. An increased role for the Fed was solidified last week when the central bank announced that the discount window would now be available to Fannie and Freddie for short-term liquidity needs. This allows the companies to tap their
19
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
combined $1.5 trillion in unencumbered assets in their retained portfolios and pledge securities, for instance, in the repo market. While critics of government intervention again cite the so-called “moral hazard” of safeguarding large financial institutions, as the Federal Reserve did when it assisted in the bailout of Bear Stearns in March, investors need to appreciate the systemic risks that these companies pose to the financial system should concerns deepen. For instance, the Fed’s stamp of approval — and the complete turnabout from the Administration — is a testament to the critical role that these companies play in the housing and securitized mortgage markets (MBSs). To put this in perspective, MBSs comprise the largest sector of the US bond market, with outstanding supply of $7.4 trillion relative to the second-largest corporate sector at $5.9 trillion, according to SIFMA.
Fannie and Freddie alone own or guarantee nearly one-half of the $12 trillion US home loan market and represent about an 80% market share of new mortgage-backed securities issuance year to date.
GSE Prospects from Here
Figure 2. Agencies versus BIG Credit Index — Option-Adjusted Spreads, Jul 07-Jul 08
110 Agencies BIG Credit Index (right) 260 90 Spread (bps) Spread (bps) 220 70
180
50
140
Both the Federal Reserve and the current Administration have been longstanding critics of these two companies and regularly called for establishing a more stringent federal regulator. Some investors might recall former Fed Chairman Greenspan testifying before Congress on the potential systemic risks posed by the size of, and leverage in, their mortgage portfolios and that the companies had deviated from the intent of their original charters. Elected Washington legislators were never receptive to these overtures, but now appear ready to act. While the situation is clearly in flux, the proposed legislation should be expeditiously passed by Congress in some form, perhaps as early as this week. That said, bond investors should recognize that the GSEs still have other financing alternatives at their disposal. For instance, besides unencumbered portfolios, core capital appears fairly robust (around $11.5 billion at Fannie Mae and $3.7 billion at Freddie Mac) and access to the debt markets is still unimpaired. For example, demand for the weekly short-term note auctions has been relatively strong over the past two weeks even as common stock and preferred securities declined substantially. Moreover, the GSE regulator (OFFHEO) has the flexibility to provide additional capital to the companies by further paring the current 20% surcharge on minimum requirements, lowered from 30% earlier this year. At least one thing appears certain, in our view: the implicit guarantee of Fannie Mae and Freddie Mac debt has become more explicit. This is reflected in wellcontained debt spread relationships and by Moody’s and Fitch, which reaffirmed the senior debt at Aaa/AAA. We continue to recommend opportunistic buying of GSE bonds given relatively attractive levels, particularly among callable issuers in the short to intermediate term. However, the rating agencies cut the preferred stock ratings of Fannie Mae and Freddie Mac to high single A last week and placed them on negative watch for further downgrades. This is consistent with our view that while securities in this part of the capital structure are still high quality and should continue paying dividends, certain risks (such as potential dividend suspension) have intensified that while seemingly remote at this time, may not be consistent with conservative investment objectives. For these investors, we recommend lightening positions during market rallies to minimize price volatility that is likely poised to persist.
30 Jul-07
Sep-07
Nov-07
Jan-08
Mar-08
May-08
100 Jul-08
Source: Citi
More direct government involvement and the perception of more explicit backing for the GSEs may actually cause more compression relative to risk-free debt as conditions normalize.
Figure 3. Ten-Year Fannie Mae Benchmark Yield and Spread, Jul 07-Jul 08
5.5 100 5.1 Yield to Maturity 4.7 4.3 60 3.9 3.5 Jul-07 40 Jul-08 80 Spread (bps)
Sep-07
Nov-07
Jan-08
Mar-08
May-08
Source: Yield Book TM
20
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Macro / Commentary
Quantitative Strategy
Sector Performances During Bear and PostBear Market Periods
Keith L. Miller / Aline Sun We identified bear market and post-bear markets periods from December 1978 to June 2008, and show sector performance for the Russell 1000 and Russell 2000 Indices during those periods. We observe that, on average, the technology sector across the large- and small-cap segments performed the worst during bear markets but was the top performer during recovery periods. Consumer Staples fared the best during bear markets but lagged during recovery periods.
Bear Markets and Post-Bear Markets
We defined a bear market as a peak-to-trough decline in the daily Russell 3000 price index of 15% or more. We identified six such markets from December 1978 to June 2008 (see Figure 1). Note that the current bear market performance is through June 2008, the last full month for which we measured historical performance. In Figure 2, we show the performance on a total return basis for the Russell 1000 Index sectors during the 12 months immediately following the end of bear markets.
Performances of the Russell 1000 and Russell 2000 Index Sectors During Bear Markets and Post-Bear Market Periods
This study is conducted using Russell sector classifications, for which there is nearly 30 years of historical performance. In Figures 1 and 2, we show the cumulative total returns of the Russell 1000 (large-cap) Index sectors and Russell 2000 (small-cap) Index sectors during each bear market and post-bear market period, respectively. For each sector, we also calculate the equalweighted average total return across all periods. We observe that, on average, the technology sector for both the Russell 1000 and the Russell 2000 indices has been the worst performing sector during bear markets. However, it has also been the best performing sector during post-bear market periods. Consumer Staples in both the large- and small-cap segments has fared the best during bear market periods. However, it has lagged during recovery periods. Similarly, healthcare, energy, and utilities sectors within the Russell 1000 have outperformed during bear markets, but have typically underperformed during the ensuing recovery periods. The financial services sector has produced fairly erratic performance throughout the different bear market periods, although, generally, it has posted relatively strong performance during the recovery periods. We also note that the Other Energy sector performance has been weak for most bear market periods with the exception of the most recent period.
21
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Figure 1. Historical Bear Markets and Russell 1000 Performance by Sector
Russell 1000 Performances By Sector During Bear Market Periods
Bear Market Periods Dec 1980 to Jul 1982 Sep 1987 to Nov 1987 Jul 1990 to Oct 1990 Jul 1998 to Aug 1998 Apr 2000 to Oct 2002 Oct 2007 to June 2008 Average Auto & Transportation -19.4% -35.6% -26.1% -19.5% -23.2% -11.4% -22.5% Consumer Discretionary 15.4% -37.0% -25.2% -18.3% -40.0% -16.5% -20.3% Consumer Staples 22.4% -27.2% -4.9% -14.2% 35.5% -8.7% 0.5% Financial Services 3.5% -30.8% -31.3% -22.6% 0.8% -36.0% -19.4% Health Care 9.0% -28.4% -6.3% -12.2% -4.8% -11.7% -9.1% Integrated Oils -43.8% -28.7% 2.6% -9.5% -7.3% 5.4% -13.5% Materials & Processing -29.9% -30.1% -19.0% -19.8% -9.1% 1.6% -17.7% Other -13.7% -32.5% -28.5% -15.2% -38.6% -27.6% -26.1% Other Energy -56.0% -31.4% -9.1% -39.1% -47.8% 30.6% -25.5% Producer Durables -29.9% -29.4% -22.0% -20.0% -37.3% -14.1% -25.4% Technology -19.0% -33.8% -24.4% -13.9% -76.3% -12.9% -30.0% Utilities 31.7% -11.5% -2.1% -4.7% -54.1% -10.0% -8.5%
Russell 1000 Performances By Sector During Post-Bear Market Periods
Post-Bear Market Periods Aug 1982 Dec 1987 Nov 1990 Sep 1998 Nov 2002 Average to to to to to Jul 1983 Nov 1988 Oct 1991 Aug 1999 Oct 2003 Auto & Transportation 84.0% 37.7% 36.8% 21.2% 28.1% 41.6% Consumer Discretionary 80.0% 32.2% 52.9% 34.9% 24.7% 44.9% Consumer Staples 31.2% 33.7% 35.2% 9.3% 8.5% 23.6% Financial Services 69.4% 25.1% 74.5% 23.8% 23.9% 43.4% Health Care 43.0% 15.9% 57.8% 24.3% 8.1% 29.8% Integrated Oils 52.1% 30.2% 15.8% 35.8% 14.6% 29.7% Materials & Processing 75.1% 21.5% 44.0% 25.0% 29.1% 38.9% Other 94.4% 22.9% 76.4% 39.4% 21.2% 50.9% Other Energy 52.8% 21.5% 2.0% 65.9% 18.8% 32.2% Producer Durables 69.4% 24.7% 27.3% 49.4% 36.9% 41.5% Technology 90.5% 5.9% 30.8% 109.4% 44.3% 56.2% Utilities 36.6% 20.3% 16.4% 37.0% 14.4% 24.9%
22
Source: Citi Investment Research and Russell Investment Group
Figure 2. Historical Bear Markets and Russell 2000 Performance by Sector
Russell 2000 Performances By Sector During Bear Market Periods
Bear Market Periods Dec 1980 to Jul 1982 Sep 1987 to Nov 1987 Jul 1990 to Oct 1990 Jul 1998 to Aug 1998 Apr 2000 to Oct 2002 Oct 2007 to June 2008 Average Auto & Transportation -8.1% -37.2% -27.9% -27.9% 0.3% -24.4% -20.9% Consumer Discretionary 16.3% -37.1% -36.0% -28.5% -18.2% -22.7% -21.0% Consumer Staples 17.7% -31.1% -20.7% -16.2% 33.9% -13.9% -5.0% Financial Services 20.8% -31.4% -30.2% -20.5% 42.3% -25.1% -7.4% Health Care 6.1% -41.4% -27.0% -29.6% -27.8% -13.6% -22.2% Integrated Oils -81.4% -12.0% -24.4% -34.4% -18.7% 70.6% -16.7% Materials & Processing -22.1% -30.2% -28.0% -27.2% -9.2% -3.8% -20.1% Other -47.2% -34.9% -28.9% -25.2% -9.3% 45.1% -16.7% Other Energy -66.2% -40.1% -13.7% -42.4% -10.9% 53.2% -20.0% Producer Durables -29.0% -38.1% -33.6% -26.5% -40.4% -8.2% -29.3% Technology -25.7% -40.4% -35.4% -30.6% -81.9% -21.4% -39.3% Utilities 21.8% -16.2% -11.3% -16.4% -47.9% -11.0% -13.5%
Citigroup Global Markets Equity Research
Russell 2000 Performances By Sector During Post-Bear Market Periods
Post-Bear Market Periods Aug 1982 Dec 1987 Nov 1990 Sep 1998 Nov 2002 Average to to to to to Jul 1983 Nov 1988 Oct 1991 Aug 1999 Oct 2003 Auto & Transportation 85.7% 43.2% 53.4% 25.3% 36.0% 48.7% Consumer Discretionary 120.3% 40.7% 66.3% 23.8% 38.4% 57.9% Consumer Staples 98.0% 41.6% 38.2% 2.3% 16.0% 39.2% Financial Services 84.4% 14.8% 77.2% 9.3% 35.8% 44.3% Health Care 110.4% 25.0% 112.5% 44.6% 50.0% 68.5% Integrated Oils 54.6% 70.1% 43.4% 49.7% 134.7% 70.5% Materials & Processing 89.5% 28.9% 37.8% 7.4% 29.4% 38.6% Other 19.6% 17.7% 58.9% 7.6% 25.7% 25.9% Other Energy 49.4% 12.6% 6.5% 43.4% 23.6% 27.1% Producer Durables 108.9% 37.0% 41.2% 30.3% 57.5% 55.0% Technology 107.8% 21.0% 71.3% 77.5% 77.9% 71.1% Utilities 52.2% 35.2% 31.4% 46.9% 32.0% 39.5%
Source: Citi Investment Research and Russell Investment Group
US Portfolio Strategist 24 July 2008
Proprietary / Proactive
Industry
Advertising
Cutting U.S. Ad Forecast, Reduce OMC to Hold; Q2 Ad Agency Preview
Catriona Fallon
We expect a particular decline in the ad mediums exposed to local advertising.
Proprietary Analysis Leads to Bearish Ad Outlook — Semiannual survey of CIR's U.S. based media analysts yields only 0.2% growth for 2008, down from 3.1% previously, and flat with 0.2% growth in 2007. Expect particular decline in the ad mediums exposed to local advertising — newspapers down 12%, radio down 5%, and yellow pages down 2% — and a 3% decline in magazines that have seen a 10%+ decline in ad pages for recent issues. Weak Economy through 2009 Puts a Crimp in Ad Spending — Citi's economic outlook is for the lowest level of GDP growth since 2001, which led to a 6.3% drop in U.S. advertising and 7.9% fall in global ad spend. While we don't envision this sharp a fall in 2009, plunging consumer sentiment makes it likely that advertisers will pull back later this year and into '09 .
As the Internet, with easier-to-measure ROI, consumes a larger share of our attention, advertisers continue to bleed budget into it.
Ad Revenue from Traditional Media Bleeds onto Internet — As the Internet, with easier-to-measure ROI, consumes a larger share of our attention, advertisers continue to bleed budget into it. Customer-centric direct marketing, sales promotion, and other marketing services should also hold up better, targeting discretionary income and drive consumers into stores. Lack of Near-Term Catalysts; Downgrading OMC to Hold —The agencies should show relatively in-line performance for Q2, but we are cautious on the outlook for Q4 and FY2009. We believe OMC is a core media holding, but given an unlikely recovery for the ad industry until late 2009/2010, we expect it to be range bound; downgrade OMC to Hold, target goes to $47.
OMC: Slowdown Warrants Multiple Contraction; Move to Hold
OMC (Hold/Medium Risk) from Buy/Medium Risk Price (16 Jul 08) Target price from US$60.00 Expected share price return Expected dividend yield Expected total return Market Cap 2M US$42.74 US$47.00 10.0% 1.5% 11.4% US$13,690M Lack of Near-Term Catalysts. Downgrading OMC to Hold—We expect the agencies to show relatively in-line performance for Q2, but caution on the outlook for Q4 and FY2009. Long-term holders may hide in OMC, but with an ad industry recovery unlikely until late 2009/2010, we expect the stock to be range bound and are downgrading OMC to Hold (2M). Target goes to $47. Not a Call on the Quarter— We expect Q2 revenue of $3.49B, up 11.6% year over year (vs. the Street at $3.45B) with US revenues growing 6.4% (5.5% organic, 0.9% acquired) and International up 17.4% (6.5% organic, 1.1% acquired, and 9.0% FX). – Revenue Breakdown - Organic growth remains solid at 6.0% but currency benefits are the primary driver of international growth, contributing ~4.4% to the top line overall, while acquisitions add another 1.2% to growth. – Net new business wins were strong through June, with sources indicating ~$1.2B in net business in Q2 including the $300m Intel deal, and other large wins at HP, Estee Lauder, and Eli Lilly.
23
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Strength in Media-Agnostic Agencies — As the consumer becomes more complex and difficult to reach, agencies become ever important. They remain media-agnostic, benefit from greater national than local exposure, contribute to the growth in digital, and have wide exposure to marketing services. Expect that OMC could be a place to hide from media weakness. Valuation — Our new $47 target price (down from $60) is based on a 13x forward P/E multiple on 2009 EPS of $3.62. While the stock has traded in the range of 11.5x–21.1x forward EPS estimates over the past five years, the economic downturn and uncertainty around '09 ad budgets will drive OMC toward the bottom of this range. We believe OMC is a core media holding, but lack of catalysts keep us on the sidelines.
Why Downgrade Now?
We continue to view Omnicom as the industry-leading advertising holding company, with a disciplined management team that has been able to execute in previous downturns. However, the economic environment is making us more bearish on ad spending through 2009. — July 17, 2008
Related Note: Omnicom Group Inc. (OMC): Rain Clouds on Advertising Horizon; Maintain Hold
Hold/Medium Risk Price (22 Jul 08) Target price Expected share price return Expected dividend yield Expected total return Market Cap 2M US$40.93 US$47.00 14.8% 1.5% 16.3% US$13,110M Softer Organic Growth and Slight Rev/EPS Miss — Omnicom reported revenues of $3.48bn (+11.2% y/y), just shy of our $3.49bn forecast, as organic growth of 4.8% (vs. 7.4% last year) missed our projection of 6.0%. EPS came in at $0.96 (+14.4% y/y), $0.01 below our estimate, but in line with the Street. Developed Markets Weakening, but Emerging Markets Holding Up — Management cited weakness in North America and developed Europe (U.K., Spain, and Italy) but indicated that LatAm, Asia, and Eastern Europe remain strong. Currency benefit of 5.2% contributed 47% of the growth in 2Q. Positioned Well vs. Peers in Shift to Mktg Svs. (57% of OMC Revenue) — CRM, where there is calculable ROI, was up 17.2%, much higher than the 9.8% growth in traditional advertising and low-single-digit growth in PR and specialty communications (recruitment, health care, and directory). Few Tweaks to Model — We are lowering our FY08 organic revenue growth outlook to 4.8% from 5.5% previously, but total revenues go to $13.96B (+10.0% y/y), from $13.91bn due to higher FX benefit (4.5% vs. 3.6% previously) and acquisition growth (1.0% vs. 0.7%). EPS is unchanged at $3.35 (+13.6% y/y). Maintain Hold and $47 Target — Our target price of $47 is based on a multiple of 13x our 2009 EPS estimate of $3.62. While we still expect the company to outperform in what will be a difficult year economically, a slowdown in ad spending merits a multiple at a discount to the S&P. — July 22, 2008
Price Performance (RIC: OMC.N, BB: OMC US)
24
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Proprietary / Proactive
Electric Utilities
Allegheny Energy Inc. (AYE)
One of the Most Undervalued Stocks in the Utility Universe: With $5.50+ of Earnings Power in 2011, Stock Worth $65
Greg Gordon, CFA
Buy/Medium Risk Price (21 Jul 08) Target price from US$70.00 Expected share price return Expected dividend yield Expected total return Market Cap
1M US$46.81 US$65.00 38.9% 1.4% 40.2% US$7,866M
Buy on Weakness — We reiterate our Buy (1M) rating on AYE. We reduced our target price from $70 to $65 due to a lower "Open" EBITDA value given a higher LT coal price assumption. Since most of AYE's power revenue in '11 will rise to market and coal price is highly hedged we believe EPS can grow from $2.24 in FY '07 to >$5.50/share in FY '11 — a 25%+ EPS CAGR. Transmission investments are also a major EPS contributor. AYE's Coal Position Is Well Hedged — AYE's YTD underperformance has been driven by perceived coal price exposure. Our lower '09/'10 estimates reflect tighter forward "dark spreads" on AYE's small open power position while profitability on fixed priced power contracts is hedged. Coal is 95% purchased in '08 at $44/ton, declining to 50% hedged at $47/ton in '12, and 40% in '17 at prices <50% of current market. We estimate AYE's post '11 coal hedges have a positive NPV of $6–$10/share vs. current coal prices (>$110/ton for CAPP coal). Questions regarding their coal hedge profile will be addressed on the Q2 call. Regulatory Developments Positive in PA and VA — On 7/17/08, the PAPUC indicated it would issue an order supporting a market transition plan for AYE, allowing hedging of forward power positions beginning 6/09 for 2011+ and allowing a cap-and-defer rate plan for consumers. On 7/18/08, the VA SCC ruled AYE's VA utility would no longer be obligated to provide power under a below-market default rate after 12/31/08. Both decisions are positive, but neither completely resolves uncertainty in those states.
AYE Company Metrics
52-Week Range Div (E) Est. 5-Yr Growth P/E (12/08E) P/E (12/09E) 12/07A EPS 12/08E Cur EPS 12/08E Prev EPS 12/09E Cur EPS 12/09E Prev EPS US$64.99–US$46.00 US$0.78 22.3% 18.3x 14.6x US$2.24 US$2.55 US$2.50 US$3.20 US$3.25
Price Performance (RIC: AYE.N, BB: AYE US)
Factoring in Higher Coal Prices and Regulatory Risk, We Think AYE Can Grow Earnings at a 25%+ CAGR Through 2011
We continue to forecast AYE having the best earnings growth potential in the Integrated Group driven by generation step-ups, improved operating performance at its coal generation fleet, and investment in high voltage transmission infrastructure. We make conservative assumptions regarding rate relief in WV and VA. We have modestly increased our '08 EPS forecast to $2.55, lowering our Q2/Q3 estimates but raising our Q4 estimate given the company’s generation outage schedule and expected power plant availability. We lowered our EPS forecast for 2009 and 2010 to reflect that fact that forward "dark-spreads" in PJM West have declined YTD, but that only impacts a small portion of AYE's output that is sold wholesale, where they take dark spread risk. The majority of their gross margin in the generation business through YE 2010 is driven by fixed price power obligations hedged with coal contracts. We base our valuation off of an "open" EBITDA model because that cash flow is more reflective of the earnings power of the company as evidenced by our 2011 earnings forecast because we think investors should value the stock
25
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
based on AYE’s longer-term earnings power, appropriately discounted for time value and commodity risk. Figure 1. AYE Earnings Snapshot
2007A Consolidated Net Income Average Shares Outstanding Consolidated EPS Regulated Utilities Incremental Transmission Generation EPS Growth Rate Source: Citi Investment Research 380.4 169.5 $ 2.24 $ 0.72 $ 0.00 $1.52 2008E 434.9 170.3 $ 2.55 $ 0.56 $ 0.07 $1.91 14% 2009E 545.1 170.3 3.20 0.60 0.24 2.36 25% 2010E 679.6 165.7 4.10 0.82 0.48 2.80 28% 2011E 879.3 159.8 $ 5.50 $ 0.84 $ 0.72 $ 3.95 34%
$ $ $ $
$ $ $ $
We expect significant earnings growth over the next several years.
We expect significant earnings growth over the next several years, driven by five key drivers: 1) generation rate step-ups in Pennsylvania; 2) roll-off of below market contracts; 3) improved capacity factors at AYE's supercritical coal plants 4) PJM approved major expansions of AYE’s electric transmission system; and 5) redeployment of free cash flow when the cash position "flipflops" in 2010 due to ebbing cap-x and rising revenues. These positives are offset by general cost inflation, but most impacted by the cost of coal.
Coal Price Exposure Is Well Hedged. Perception of Risk Is Overblown as Operating Leverage Overwhelms Cost Escalation
Year to date, AYE is one of the worst performing stocks in the utility index down over 25%.
YTD, AYE is one of the worst performing stocks in the utility index down over 25%. Underperformance, from our perspective, has been driven by investors’ focus on the potential for rising coal prices impacting future profit margins and perhaps inherent negative exposure to implementation of carbon caps on their long term profitability. We think this pullback is a buying opportunity. Given their coal contract position we don't see much earnings exposure through YE 2010. They are exposed to the dark spread on +/- 10TWH of annual power generation output and dark spreads given the make up of their local power markets (in which prices are set by coal on the margin a large percentage of the time). AYE's fixed price obligations (retail load and PA POLR) are matched with fixed price coal contracts through 2010. Recent concerns that a portion of AYE's longer term coal hedges may not perform appear to be overstated. In particular, yesterday AYE issued a press release indicating that its 2mm ton/year agreement with Alliance Resource Partners L.P. had been renegotiated given delays in ARLP opening a mine at the 50mm ton reserve called Buffalo Creek they have leased from AYE. Figure 2. AYE's Coal Contract Positions and Cost
2008E % of Total Coal Needs Hedged Average Delivered Coal Cost ($/ton) >95% $44.00 2009E 60% $43.00 2010E 60% $43.00 2011E 60% $45.00 2012E 50% $47.00
Source: Citi Investment Research
— July 21, 2008
26
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Proprietary / Proactive
Industry
Drugs & Ophthalmology
U.S. Major Pharmaceuticals Initiation of Coverage: Evolving Business Model
John Boris We initiate coverage of six pharmaceutical companies — MRK, BMY, LLY, SGP, WYE, PFE — and assume coverage of one ophthalmology company — AGN. We have a Buy rating on MRK and the rest are Holds. Sector View — U.S. major pharmaceuticals’ business models have evolved from the 1990’s “Golden Age” of pharmaceuticals to the present. Companies have seen changes in their sustainable long-term revenue and EPS growth due to the five Ps: Patent expiration, Product volumes, Pipelines, Pricing and Politics.
See our full July 17 notes for complete analyses of each company.
From 1967 to 2007, the median relative drug P/E was a 33% premium to the S&P. In 2008, the median relative drug P/E declined to a 5% discount. P/E expansion over the next 12 months appears unlikely due to the decline in the sector’s long-term growth rate (as the 2010–13 patent “cliff” nears). We note the U.S. drug 2002–07 pharma sales CAGR was 5% vs. our forecasted 1% CAGR for 2008–13. There is also the increasing intensity of political rhetoric plus difficult comps in 2008 as Part D benefits anniversary and formularies tighten. If the market gradually believes increased government intervention on pricing is a real possibility, more dramatic P/E erosion is possible. If the industry is able to substantially regenerate its pipeline, or corporate credit concerns in the market become meaningfully more problematic, the sector may be able to maintain its multiple, or possibly show modest expansion. What’s the Downside? The historical troughs in pharma valuations were in a range of a 3%–22% discount to the P/E, implying a 30% theoretical downside from current levels (median drug P/E is a 22% discount to the S&P) in a highly negative scenario. In 1993–94 Clinton healthcare reform risk: Drug stocks traded at a 22% discount to the S&P (13x prospective EPS) in Feb. 1993, during the proposed reform of the U.S. healthcare system by the Clinton administration. 2000 Sector rotation: Valuations bottomed at a 20% discount to the S&P (25x prospective EPS) in August 2000, as investors rotated out of defensive sectors and into technology, media and telecom stocks 2004 Vioxx withdrawal and presidential election: Valuations bottomed at a 3% discount to the S&P (15x prospective EPS) amid fears of a Democrat gaining control of the White House in a close presidential election, as well as the Vioxx withdrawal. Dividend Yield Could Provide Support: The drug industry has attractive dividend yields, which are currently 4.1% and now greater than the 10-year Treasury yield at 3.88%, which is unprecedented in the past 45 years.
27
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
2010–13 Patent “Cliffs” Challenge Long-Term EPS Growth: From 2008 to 2014, ~$47 billion of sales lost to patent expirations will weigh on the sectors top line growth, pointing to dramatic year/year EPS deceleration from +8% in 2008 to 4% in 2011 to -6% in 2013 (2008–13 CAGR of 1%) Will Cost Cutting Offset the New Drug Deficit? Cost savings appear unlikely to offset the new drug deficit. It is reasonable to assume the industry will reinvest a significant portion of savings from these cost cuts for future growth prospects. If the Democrats were to gain control of the White House and the 60 votes needed in the Senate to implement a more onerous Part D pricing system, we believe that increased M&A activity may be on the horizon to achieve further cost savings
Merck (MRK): Is the Glass Half Full or Half Empty?
We initiate coverage of Merck (MRK.N; US$35.33; 1M) with a Buy/Medium Risk rating. Our revised $42 price target (down from $44, see our July 22 note) assumes MRK trades at ~11.1x our 2009E EPS of $3.79.
MRK Valuation: Our revised $42 price target assumes MRK trades at ~11.1x our 2009E EPS of $3.79.
Performance rests on its ability to execute on new products and late-stage pipe to address patent expirations (Cozaar/Hyzaar '10; Singulair '12). The company recently suspended its '08 and long-term guidance citing uncertainty created by the SEAS trial on its equity income line and EPS. We see lower-thanexpected Singulair/Gardasil sales playing a role; however, these products are in monopoly positions. Furthermore, we believe MRK needs to improve performance of these product lines in order to reinstate its FY08 range ($3.28– $3.38) and long-term guidance. We maintain our FY08/09 estimate of $3.34/$3.79 vs. consensus $3.31/$3.64). 2008–11 sales and EPS growth rates are +4% and +11%, above the group average growth rate of +4% and +8%.
Bristol-Meyers Squibb (BMY): Patent Cliff Masking Near-Term Growth Outlook Risks
We initiate coverage of Bristol-Myers (BMY.N; US$22.38; 2M) with a Hold/Medium Risk rating and $23 price target.
BMY Valuation: Our $23 price target assumes BMY trades at ~11.5x our '09E EPS of $2.00, representing ~5% premium to its peers. BMY's superior operational growth outlook, attractive pipeline, ~5.5% dividend yield and prospects for M&A as its "patent cliff" approaches should limit downside risk from current levels.
Revenue and Earnings Growth — Our 3-year (2008–11) sales and EPS CAGRs are 6% and 15% (ex-Convatec) is materially higher than the group's average CAGRs of +4% and +8%. Generic Plavix risk in the EU (~$0.20 or earnings or a DCF value of >$1 per share) and Effient competition are overhangs. We project above-average 3-year (2008–11) incremental pharma sales of $4B supported by robust growth from inline brands and improving new product performance. BMY's pipeline score is above its peer group average, with 51% of its score in late stage assets. Management Focused on Increasing Shareholder Value — BMY is delivering top tier growth, with improving margins and cash flow. Gross margin (GM) improved to 68.8% (+100bps y/y) in '07, with GM likely to surpass 70% by 2010. We project FCF to grow +41%/+19%/+18% in '08, '09, and '10. Patent Risk — BMY has limited generic exposure until 2012 when >45% of its revenues lose exclusivity between 2012 through 2014.
28
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Eli Lilly (LLY): Effient Is the Leading Indicator
We initiate coverage of LLY (LLY.N; US$48.28; 2M) with a Hold/Medium Risk rating and $52 target price. FDA action on Effient (9/26) is the most important event for the stock.
LLY Valuation: Our $52 price target assumes LLY trades at 12x our 2009E EPS of $4.30. Lilly trades at ~11x our '09E EPS, representing 6%/9% discounts to its peers/S&P and at the low end of its 15-year historical range (9x to 41x).
Effient Sensitivity Implies Upside — Our Effient scenario analysis suggests an attractive risk/reward for LLY's shares. Our worst-case Effient scenario appears already priced into LLY's shares. Our non-risk adjusted scenario ($1.75B) yields $58/share and the optimistic scenario ($3.50B) yields $62. Revenue and Earnings Growth — Our 3-year (2008–11) revenue/EPS CAGRs are 6%/5% vs. the group's average CAGRs of +4%/+8%. We expect Lilly to generate $3.5B of incremental pharma sales from 2008–11 and $2.3B from 2008–13. Pipeline — LLY's pipeline score is above its peer group average, with 38% of its score in late-stage assets. We view Lilly's pipeline as attractive and undervalued, with investors getting a free call option. Patent Challenges and Expirations — Over the next five-years, several key growth drivers (Zyprexa, Evista, Gemzar, Cymbalta) face generic competition. In addition, Lilly faces a number of P-IV patent challenges (Evista, Gemzar, Strattera, Cymbalta anticipated in August). The outcome of these challenges and level of late-stage pipeline success are critical for sustaining long-term growth.
Pfizer (PFE): Growth Outlook Troubling
We initiate coverage of Pfizer (PFE.N; US$18.26; 2H) with a Hold/High Risk rating and $18 price target. Our 3-year (2008–11) revenue and EPS CAGRs are 2% and 2% vs. 4% and ~8% for the industry (0% and 3% for consensus).
PFE Valuation: Our $18 price target assumes PFE trades at ~7x our 2009E EPS. PFE trades at 7.3x our 2009E EPS, a ~35% discount to peers; the discount falls to 12% if we exclude our $4/share DCF value for Lipitor. The 2011–13 patent cliff ($9.2B/42% of US pharmaceutical sales) and negative US cash flow position must be addressed to support its attractive 7.0% dividend yield.
Base Business Eroding — PFE's U.S. ops are under considerable stress as two-thirds of PFE's U.S. in-line product sales are seeing volumes decline. Negative U.S. total prescription (TRx) trends coupled with label changes to new products and rebating demands from payors are impacting ops. This makes PFE dependent on price/FX/cost saving initiatives for growth, which is not a sustainable strategy. PFE needs to make additional cost cuts to offset U.S. weakness. Negative Incremental Sales Growth — Our negative $5.2B incremental pharma sales estimate (2008–13) is exacerbated by operational performance, limited pipeline and an unprecedented 2011–13 patent cliff. These issues limit a return to sustainable long-term growth without M&A or breaking up the company.
Schering-Plough (SGP): Risk/Reward Attractive as Long as U.S. Cholesterol JV Grows
SGP Valuation: Our $21 price target assumes SGP will trade at a 10%–20% premium to the U.S. drug multiple of ~11x on our 2009E EPS estimate.
We initiate coverage of Schering-Plough (SGP.N; US$18.95; 2H) with a Hold/High Risk rating. Our revised $21 price target (down from $23, see our July 22 note) assumes SGP will trade at a 10%–20% premium to the U.S. drug multiple of ~11x on our 2009E EPS estimate. Our 3-year (2008–11) revenue and EPS growth rates are 4% and 13%, respectively, vs. 4% and ~8% for the
29
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
industry (5% and 16% for consensus). Pipeline contribution coupled with a lack of a material generic risk should contribute $3.1B in incremental pharma revenue over 2008–13 coupled $1.5B in cost savings, setting the stage for significant operating leverage from cost cutting. EMEA/FDA action on golimumab/sugammadex, asenapine could be meaningful catalysts over the next 6–12 months.
Wyeth (WYE): Equivocal Bapineuzumab Data Masking Operational Issues
WYE Valuation: Our $49 price target is based on relative P/E. We assume WYE trades at ~13x our '09E EPS of $3.71. WYE trades at ~20% premium to its peers (13x our '09E EPS) reflecting material upside from bapineuzumab, which is masking near-term operational issues.
We initiate coverage of WYE (WYE.N; US$48.29; 2H) with a Hold/High Risk rating and $49 price target. Our 3-year (2008–11) revenue and EPS growth rates are 1% and 4%, respectively, vs. 4% and ~8% for the industry. Sustainable Long-Term Growth — We expect WYE to shift its business model to specialty markets. We see upside to our estimates from limited U.S. generic competition to Zosyn/EffexorXR. The uptake of Pristiq/Restilor and material pipeline setbacks Pristiq-VMS/Viviant/Aprela/bifeprunox will result in deeper Project Impact cost saving initiatives to facilitate its transformation. The biologics shift (Prevnar/Enbrel) will carry growth and profitability, contributing ~41% of WYE's 2011E sales (up from 29% in 2007) and ~60% of its EPS. However, our 3-year incremental pharma revenue estimate is flat, with limited pipeline visibility until Prevnar 13 valeant in 2010 (pediatrics)/2011 (adult) and bapineuzumab in 2011/12.
Allergan (AGN): Follow the Leader
We assume coverage of Allergan (AGN.N; US$51.52; 2M) with a Hold/Medium Risk rating and $54 price target. Our 3-year (2007–10) sales and EPS CAGRs are 12% and 18%.
AGN Valuation: AGN shares trade at 16.4x our 2009 EPS estimate of $3.14 (+20%). The valuation reflects a 47% discount to AGN's 5-year average forward multiple of 24.1x (16.4x–29x range).
Aesthetics Growth an Issue in a Slowing Economy — AGN's U.S. aesthetics franchise weakness could lead to contagion of ex-US markets in subsequent quarters. The impact appears to be hitting AGN's most expensive breast aesthetics segment followed by dermal fillers and Botox. Botox Competition a Key Consideration — AGN's Botox platform provides multiple cross-selling opportunities in its well-constructed portfolio. We estimate Botox accounts for ~30% of sales and 50%–58% of EPS through 2012, with leverage built into our model. We assume AGN's SG&A margin goes from 42.1% in 2007 to a more normalized 38.0% in 2012. U.S. competition from Ipsen/Medicis expected in late 2008 (therapeutic)/2009 (cosmetic). Botox Sensitivity Analysis — Our 3-year $1.6B incremental sales projection is driven by eight distinct franchises, reflecting the diversity of AGN's growth drivers. Botox needs to perform well in the face of rising competition. Our 3year EPS CAGR declines to 15% from 18% under a more competitive Botox scenario. — July 17 & 22, 2008
30
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
On the Contrary
Specialty / Mortgage Finance
Discover Financial Services (DFS)
AXP’s Negative Trends May Weigh on DFS Too
Bradley Ball
Sell/High Risk Price (21 Jul 08) Target price Expected share price return Expected dividend yield Expected total return Market Cap
3H US$15.19 US$14.00 -7.8% 1.6% -6.3% US$7,281M
Tough Trends — The recent release of AXP’s weaker-than-expected 2Q08 results and worse guidance for the balance of ‘08 does not bode well for DFS. In particular, we believe business deterioration over the course of 2Q08, culminating in higher net charge-offs (NCOs) and lower spending growth, suggest that DFS’ core U.S. card unit may be facing weakening trends as well. Environmental Challenges — AXP cited several areas of business deterioration in its U.S. card services business which resulted from lower home prices, higher unemployment, and deteriorating consumer confidence. June Bug — First, card spending growth fell over the quarter, hitting a cycle low point of 2% YOY in June. Second, U.S. lending monthly roll-rates tickedup in June for both current to 30 days past due and 30 days past due to write-off. Third, U.S. lending NCOs rose in April and May, and then spiked higher in June — reflecting sharply worse trends across all of AXP’s customer segments and tenures. The upshot is that the economy deteriorated sufficiently in the month of June to drive surprisingly weak spending and credit performance metrics, which look likely to carry over into at least the second half of 2008. Maintain Sell — Accordingly, to reflect increased expected NCOs, lower credit card purchase volume, and lower loan growth rates over the foreseeable future, we are lowering our EPS to $1.50, $1.60, and $1.70 for ’08, ’09, and ’10, respectively. Also, we are maintaining our Sell rating and our $14 target price. AXP cited several areas of business deterioration in its U.S. card services business which resulted from lower home prices, higher unemployment, and deteriorating consumer confidence. First, billed business (spending) growth fell over the quarter, hitting a cycle low point of 2% YOY in June. Second, U.S. lending monthly roll-rates ticked-up in June for both current to 30 days past due and 30 days past due to write-off. Third, U.S. lending net write-off rates rose in April and May, and then spiked higher in June – reflecting sharply worse trends across all of AXP’s customer segments and tenures. The upshot is that environmental conditions apparently deteriorated sufficiently during the month of June to drive surprisingly weak spending and credit performance metrics, which look likely to carry over into at least the second half of 2008.
DFS Company Metrics
52-Week Range Div (E) Est. 5-Yr Growth P/E (11/08E) P/E (11/09E) 11/07A EPS 11/08E Cur EPS 11/08E Prev EPS 11/09E Cur EPS 11/09E Prev EPS US$26.12–US$12.55 US$0.24 NA 10.1x 9.5x US$1.79 US$1.50 US$1.55 US$1.60 US$1.75
Price Performance (RIC: DFS.N, BB: DFS US)
These negative trends are especially troubling since they are evident across all consumer segments.
These negative trends are especially troubling since they are evident across all consumer segments, even AXP’s longer-term superprime card customers – including those with FICO scores in the mid-700s. Since DFS’s credit card portfolio mix includes a high proportion of generally higher FICO borrowers who are traditionally considered to be more immune to weaker macro economic trends, we are concerned that DFS may face similar credit and spending pressures over the near- to intermediate-term. Nevertheless, we would note that DFS’ lending growth has remained at only about one-third of AXP’s growth
31
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
rate in recent years, and growth moderated further during DFS’ 2Q08 at only 2%. This may help insulate DFS from the rapid acceleration in delinquencies and losses that forced AXP to take a large ($600 million) 2Q08 provision. Accordingly, to reflect increased expected NCOs, lower credit card purchase volume, and lower loan growth rates over the foreseeable future, we are lowering our EPS to $1.50, $1.60, and $1.70 for ’08, ’09, and ’10, respectively.
Recent Results Benefited from Lower Provisioning
DFS reported 2Q08 EPS on June 26, 2008 of $0.42, $0.05 above our estimate and consensus due to lower than expected loss reserves as the company. All in, 2Q08 results benefited mainly from lower loss provisioning, which were 98% of net charge-offs (a reserve release) that we view as lower-quality earnings given our expectation of worsening credit performance through the remainder of the year. DFS grew managed credit card loans by 2% y/y to $47.8 billion, somewhat below our estimate, but consistent with lower use of balance transfer products, which management guided to last quarter. NCOs rose 62 bps in 2Q08 to 4.99%, up from 4.37% in 1Q08, and in-line with our estimate of 5.00%. Delinquencies over 30 days fell by 8 bps, to 3.85%, down from 3.93% in 1Q08. Management raised 2008 NCO guidance to above 5% (from 4.75%-5.00%) and mid-5% in 4Q08. Highlights of the quarter include better than expected net interest margin (calculated at 8.58% vs. 8.05% last quarter) resulting from lower than expected interest expense, and lower than expected operating expenses (primarily lower marketing expense). Negatives include higher NCOs and lower fee income ($492 mil vs. our $594 million estimate). One-Time Items. DFS’ 2Q08 included two unusual items totaling $76 million, including: 1) a write-down of the residual interest in off-balance sheet receivables ($44 million pre-tax) due to expectations for higher losses and increased likelihood of higher interest rates; 2) a write-down of an assetbacked commercial paper investment totaling $31 million pre-tax that was previously disclosed near the end of May; 3) a $25 million charge related to implementing the accounting treatment of balance transfer fees; and 4) a $29 benefit from changes in reward liability forfeiture assumptions. Adjusting for these charges, DFS’ 2Q08 EPS would be increased by roughly $0.09. Management Guidance. Management provided updated guidance for certain performance metrics, including: 1) a 2008 NCO rate somewhat above 5.0% (vs. prior guidance of 4.75%–5.00%) and to the mid-5% range by the fourth quarter; 2) increased use of installment loans in place of balance transfers; 3) y/y loan growth similar to 2Q08 (up 2%); and 3) retaining a higher amount of capital and no share repurchases until potential accounting changes to FAS 140 and FIN 46R are resolved. Prior guidance not reiterated this quarter includes 1) a tax rate between 37.5%–38.5% in 2008; and 2) marketing spending similar to 2007 levels. — July 22, 2008
32
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Insights
Industry
Independent Refiners
The “Lost” Year but Value Remains: Lowering EPS and Targets
Faisel Khan, CFA The Year is Lost…— Refiners will continue to face pressure this year from weak domestic product demand and lagging residual fuel/asphalt prices. We estimate resid prices are impacting current margins by $2.25 per barrel and lower utilization rates are dampening income given negative operating leverage. ..But Strategic Value Remains — Despite these concerns, we believe strategic value exists for refiners in the Midwest and Gulf Coast from steady and growing streams of Canadian heavy crude. Furthermore, the economics of building upgrading and refining capacity in Canada is becoming increasingly uneconomic given the cost advantage of assets here in the US. We estimate US refiners could command a $20–$27 per barrel advantage versus new upgrading capacity in Alberta (see analysis in full July 17 note). Furthermore, we estimate Gulf Coast refiners have a $9 per barrel advantage on proposed export refineries in the Middle East. Lowering earnings — Our estimates decline by 40% for VLO and turn to losses for TSO and SUN. We are cutting our margin assumptions for the rest of 2008 and 2009, reflecting our assumptions of wider residual fuel oil differentials ($35/bbl vs $20 before). We are also lowering utilization rates given a weaker gasoline margin outlook. Accordingly, we are lowering our target prices. Risk rating for SUN goes to Speculative (S). Recommendations — We believe VLO will outperform peers over the next 6– 12 months given its advantaged crude slate and ability to be profitable in this difficult environment. We believe MRO’s strategy in moving to a 2-1-1 configuration (more diesel) in the Gulf and expansion in Detroit to take Canadian crude is value additive rather than imbedded expectations of value destruction.
Figure 1. Rating and Target Price Changes
Ticker MRO SUN TSO VLO Price 17-Jul US$43.53 US$36.68 US$17.85 US$33.56 Rating Old New 1H 1H 2H 2S 2S 2S 1H 1H Target Price Old New US$79.00 US$74.00 US$51.00 US$41.00 US$30.00 US$20.50 US$59.00 US$49.00
Source: Citi Investment Research
Figure 2. EPS Estimate Changes
Current Year Old New US$7.10 US$6.66 US$3.04 US$-0.24 US$1.30 US$-1.19 US$5.54 US$3.07 Next Year Estimates Old New US$8.65 US$8.06 US$3.99 US$3.05 US$3.93 US$2.28 US$6.54 US$5.08
Ticker MRO SUN TSO VLO
Source: Citi Investment Research
Challenges Continue for Refiners
Figure 3. WTI – GC 3% Residual Fuel Differential
$50.0 $45.0 $40.0 $35.0 $30.0 $25.0 $20.0 $15.0 $10.0 $5.0 $0.0 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Average
We estimate that refiners on average will not earn their cost of capital this year and believe there is a risk the industry may not be able to meet its cost of capital next year. Current stock prices seem to be imbedding perpetual value destruction for the group. With the peak gasoline season coming to an end, there seems to be very little visibility on a recovery in gasoline demand through the end of the year. However, lower gasoline demand is not the only variable weighing on refining margins. We estimate the large absolute spread between crude oil and residual fuel prices are causing a 20% impact on our long-term refining margin assumptions. The only reprieve for this margin deficit would have to come in the form of a continued pull back in crude. Despite these difficulties, we believe some refining assets have long-term strategic value given the amount of heavy crude coming online from Canada and the exploding cost of proposed refineries in the Middle East and Asia. We
Source: Bloomberg, Citi Investment Research
33
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
continue to recommend Valero (VLO) as the only name in the independent refining group because of its scale and advantaged crude slate. Our recent visit to the Canadian oil sands only reinforces our view that Marathon’s (MRO) Detroit refinery conversion/expansion project will add long-term value for shareholders ($20+ per barrel advantage versus a new upgrader). Furthermore, continued international demand for distillate (diesel) gives us confidence in MRO’s Garyville expansion project (2-1-1) will yield approximately a $4 per barrel advantage over a 3-2-1 configuration at today’s prices. We do not include any this margin expansion in our estimates for MRO. We continue to believe MRO is an underappreciated upstream story rather than the challenged downstream story reflected in the current stock. Figure 4. Gulf Coast 321 vs. Refiner Yield Adjusted Margin for Resid
$50.0 $40.0 $30.0 $20.0 $10.0 $0.0 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 ($10.0) Jul-08
Reducing Estimates and Valuation
We reduce our 2008 estimate for VLO by 47% and move our estimates for TSO and SUN from a profit to a loss. We also reduce our 2009 estimates by 22%, 24% and 42%, respectively, to factor in higher absolute residual fuel to crude oil discounts. We model a return to historical levels by the end of 2009.
Widening Gap
Gulf Coast 321
Yield Adjusted Margin
Source: Bloomberg, Citi Investment Research
We lower VLO, SUN and TSO target prices to $49, $41 and $20.50 and raise our risk rating on SUN to Speculative given significant exposure to Nigerian crude that remains unpredictable and continues to trade at a premium to benchmark WTI and Brent. The primary impact to our valuations is our revised estimates of capacity utilization across the sector and the negative impact of lower realization from residual oil discounts over the next 12–18 months. Our key assumption in our valuation work is that the industry can eventually achieve its cost of capital. Assuming normal operating costs (i.e. historical natural gas prices), we continue to estimate long-term Gulf Coast 3-2-1 crack spreads of $9.50 per barrel.
Figure 5. CIR U.S. Refining Margin Assumptions
2007A 2007 FY GC 321 PADD I (East Coast) PADD II (Midwest) PADD III (Gulf Coast) PADD V (West Coast) 12.94 10.67 17.50 13.43 15.09 2008E Q108 7.77 7.01 7.87 8.29 7.42 Q208 10.73 11.59 13.34 12.96 11.74 Q308 8.25 7.43 9.90 8.66 9.49 Q408 6.00 6.00 7.20 6.30 8.90 Q109 6.75 6.08 8.10 7.09 9.74 Q209 11.50 10.35 13.80 12.08 15.29 2009E Q309 9.75 8.78 11.70 10.24 13.25 Q409 7.75 6.98 9.30 8.14 10.91 2010E 2010 FY 9.50 8.55 11.40 9.98 12.95
Source: OPIS, Citi Investment Research Our conclusion is that the next 6-18 months will remain difficult for refiners on the operating side of the equation; however, we believe there are a few industry trends taking place over the next two years that make some refining assets strategically positioned to create longterm value for shareholders. We believe Valero and Marathon’s downstream assets are positioned for these trends.
Our assumption is based on the independent refiners being able to cut runs to bring gasoline inventories back into balance which in turn should move crack spreads up to cost of capital levels. Balancing production in an environment of falling gasoline demand is difficult because of its affect on operating leverage. If refiners cut runs, the hurdle rate on the crack spread becomes higher in order to achieve a cost of capital return. — July 17, 2008
34
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Insights
PC & Enterprise Hardware
International Business Machines Corp. (IBM)
Another Clean Beat and Raise; Reiterate Buy
Richard Gardner
Buy/Medium Risk Price (17 Jul 08) Target price Expected share price return Expected dividend yield Expected total return Market Cap
1M US$126.52 US$157.00 24.1% 1.3% 25.4% US$173,773M
Quick Call — IBM is firing on all cylinders, delivering revenue upside and impressive growth in all product divisions, industry verticals and geographic regions. Pre-tax margins expanded year over year (yoy) in every reported segment during 2Q. We expect these dynamics to persist for the rest of 2008, driving the shares to $130-140 by year-end. Broad-Based Strength — IBM exceeded revenue estimates in every segment, with particular strength in Rational software, information management software, mainframe, UNIX servers, and Lotus software. New mainframe and UNIX server products are fueling the strong product cycles. Aside from a 5% yoy decline in Intel-based servers, there were no signs of weakness. Impressive Services Bookings — Short-term services signings grew a very respectable 9% yoy in constant currency, and while long-term signings were flat yoy in constant currency, this was better than the Street feared. Services performance continues to benefit from several years of reorientation toward practices that help customers reduce costs and capital requirements. Raising Guidance Again — Management raised 2008 EPS guidance yet again from “at least $8.50” to “at least $8.75” (+22% yoy). Since January 1, IBM has increased 2008 EPS guidance by $0.85. Given 2Q’s outperformance, even the new guidance strikes us as conservative and we are raising our FY08 EPS estimate from $8.54 to $8.85. IBM could potentially achieve the low end of its 2010 EPS target of $10-11 per share one full year early. Prior to 2Q results, we were confident in IBM’s ability to meet or exceed 2008 consensus revenue and EPS estimates based on foreign exchange, acquisitions, and emerging market growth being likely to generate more than 100% of the revenue growth expected by the Street, while declining pension expense and share repurchase were likely to generate fully two-thirds of the EPS growth expected by the Street. With the added tailwinds of strong shortterm services bookings, exceptionally strong customer reception to new mainframe and UNIX server products, and continued share gains in software, we are even more confident in IBM’s ability to exceed revenue and EPS expectations for the balance of 2008. Moreover, we now believe the company is likely to hit the low end of its $10.00-11.00 2010 diluted EPS target almost a full year ahead of schedule. While EPS growth is likely to slow in 2009 due to difficult server revenue comparisons, difficult Services margin comparisons, and less benefit from pension and share repurchase, we still expect doubledigit EPS growth next year. In this light, the current forward-12-month P/E multiple of 13.5x does not seem rich and we view the likelihood of significant multiple contraction as low. This suggests to us that the shares are likely to trade into the $130-140 range by year-end. Our longer-term valuation analysis continues to suggest a 12-month price target of $157 (+24% vs. the current price). We therefore reiterate a Buy rating on the shares.
IBM Company Metrics
52-Week Range Div (E) Est. 5-Yr Growth P/E (12/08E) P/E (12/09E) 12/07A EPS 12/08E Cur EPS 12/08E Prev EPS 12/09E Cur EPS 12/09E Prev EPS US$129.71–US$97.59 US$2.06 8.0% 14.3x 12.9x US$7.13 US$8.85 US$8.54 US$9.84 US$9.79
Price Performance (RIC: IBM.N, BB: IBM US)
35
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
IBM Produced a Great 2Q08
IBM beat our revenue estimates in every product segment, with particular strength in software and hardware. Total revenue of $26.8B (+12.8% yoy) was well above our estimate of $25.6B and consensus of $25.9B. Gross margin of 43.2% was well above our estimate of 42.6%, due primarily to better-thanexpected Consulting and Software margins. Diluted EPS of $1.98 were well above our estimate and consensus of $1.82-1.83 due to higher-than-expected revenue and gross margin and lower-than-expected pension expense.
Key positives
Mainframe revenue grew 32% yoy, the highest growth rate since 2004 and impressive acceleration versus 1Q’s 10%. Customer reception to the new z10 mainframe has been so strong that IBM sold out of it during 2Q. Software revenue of $5.6B was an impressive 7% above our estimate, driven by Branded Middleware growth of 21% yoy, up from 19% in the prior quarter. Rational software (+37% yoy), Information Management Software (+30% yoy including Cognos with more than 30% yoy growth in distributed relational database) and Lotus (+21% yoy) were standout performers. System p server revenue grew an impressive 29% yoy, with 68% growth in the mid-range and 21% growth in the high-end. With the Power6 microprocessor and industry-leading virtualization offerings, IBM maintains a commanding price/performance and virtualization lead over the competition and continues to gain significant market share as a result. Short-term Services bookings grew an impressive 9% yoy in constant currency following strong 7-10% growth in the previous two quarters. IBM does not appear to be seeing any significant slowing in consulting momentum within its target practices and geographic regions. Growth and revenue upside was exceptionally consistent across product lines, geographic regions, and industry verticals. Even the Financial Services vertical generated revenue growth of 15% in dollars and 6% in constant currency globally, which was generally in line with the corporate average. High-growth emerging markets represented 18% of total revenue and grew 21% yoy in dollars and 14% in constant currency. These regions generated almost half of IBM’s total constant currency revenue growth. Gross and pre-tax margins expanded yoy in every reported product segment except Software. Pre-tax margins expanded modestly yoy in Software despite additional costs associated with the Cognos and Telelogic acquisitions.
Sole Negative
Revenue from Intel-based System x servers declined yoy for the first time since 1Q02, with management citing execution and sales issues. However, revenue from high-end System x servers and blades, both of which should benefit longer term from the adoption of X86 server virtualization technologies, grew double digits. — July 18, 2008
36
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Insights
Industry
Machinery
Caterpillar (CAT): Still a Revenue Bull; Timken (TKR): Updating Estimates
David Raso
CAT: Still a Revenue Bull, Margin Cautious, Adding Up to Continued EPS Growth; Next Major Catalyst: October’s Initial 2009 Guidance
Buy/Medium Risk Price (22 Jul 08) Target price Expected share price return Expected dividend yield Expected total return Market Cap 1M US$74.98 US$106.00 41.4% 2.2% 43.6% US$46,095M Updating Estimates Post 2Q — Following up on our initial analysis of CAT’s 2Q rpt, our new model for CAT tweaks our EPS ests slightly lower to reflect a little more caution on margins (raw material costs) & lower CAT Financial income (higher loan loss reserves forecast). Our Street-high ’08 EPS est goes from $6.34 to $6.28, well above mgmt’s “approximate $6.00” EPS guidance. Our Street-high ’09 and ’10 ests are trimmed from $7.41 to $7.28 and $8.73 to $8.56. Note each new estimate represents 16%+ EPS growth each year. Despite tweak to EPS, new ests for sales, EPS, EBITDA & net debt combine to maintain $106 tgt price. Dividend annual run rate now $1.68. Thesis Intact, ’09 Initial Guidance Next Milestone — Revenues, not margins, are the most important factor for sustainability of machinery cycles, and as it stands now, we still see annual double-digit CAT rev growth through ‘10 with continued EPS growth, despite mature economies, in a downturn, unprecedented by CAT and underpinnings of a revaluation higher for CAT (and machinery sector). Some may note 2H guidance is below consensus, but that’s “missing the forest for the trees” (we believe guidance is beatable). When CAT rpts 3Q in Oct, we expect guidance of rev growth and EPS growth of at least 5%-10% (our model forecasts 11.5% rev growth, 16% EPS growth). And if ’09 is not a down year, with NA machines finding a bottom in ’09 (our view) after declining since ’05, investors may come to embrace that a down EPS year for CAT may still be years away. Greatest risks: emerging mkts fighting inflation, overshooting, slowing growth sharply. Figure 1. Tweaks to Our Model Trim Our EPS Estimates Modestly But Modeling Analysis Still Supports 16%+ EPS Growth Each Year From 2008-2010
Citi Investment Research Modeling Changes for Caterpillar
Sales Machinery Engines Total Co. Net Sales Operating Margins Machinery Engines Total Co. Oper Profit CAT Financial equity inc. ($m) Share count (mil.) E2008 OLD NEW 10.2% 11.9% 17.0% 20.4% 12.4% 14.6% E2008 OLD NEW 8.6% 8.0% 16.3% 16.2% 11.2% 10.8% $540 631.8 $6.34 $529 631.6 $6.28 E2009 OLD NEW 12.3% 12.1% 13.3% 10.1% 12.6% 11.5% E2009 OLD NEW 9.1% 8.5% 16.4% 16.8% 11.5% 11.3% $581 617.5 $7.41 $530 613.6 $7.28 E2010 OLD NEW 11.6% 12.2% 8.1% 5.6% 10.0% 10.0% E2010 OLD NEW 10.0% 9.4% 15.9% 16.4% 11.9% 11.7% $624 598.0 $8.73 $570 591.3 $8.56
CAT Company Metrics
52-Week Range Div (E) Est. 5-Yr Growth P/E (12/08E) P/E (12/09E) 12/07A EPS 12/08E Cur EPS 12/08E Prev EPS 12/09E Cur EPS 12/09E Prev EPS US$85.28–US$62.47 US$1.74 8.0% 11.9x 10.3x US$5.37 US$6.28 US$6.34 US$7.28 US$7.41
Price Performance (RIC: CAT.N, BB: CAT US)
EPS
Source: Citi Investment Research
— July 22, 2008
37
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
TKR: Updating Estimates Post This Morning’s Pre-Announcement
Buy/High Risk Price (21 Jul 08) Target price Expected share price return Expected dividend yield Expected total return Market Cap 1H US$34.81 US$48.00 37.9% 2.0% 39.8% US$3,343M Raising Our EPS Ests — Post Timken’s positive pre-announcement this morning, we are raising our previous Street-high estimates. Our 2008 EPS estimate is increased from $2.99 to $3.20 (new guidance is $2.95-$3.10). Our 2009 EPS estimate is increased from $3.58 to $3.64 (consensus $3.28) and our FY10 estimate is raised from $4.16 to $4.18. We are aintaining our ’09 valuation multiples on our new 2009 sales, EBITDA and EPS estimates (only very modest changes) maintained our $48 tgt price. Our Note Earlier This Morning — Please see our note from earlier this morning, "TKR: Street Continues to Underestimate TKR — Pre-Announces 2Q Upside/FY08 Guidance Raised; Reiterate Buy, $48 Target" with our thoughts on Timken and its positive pre-announcement this morning. Timken remains our top small cap pick.
TKR Company Metrics
52-Week Range Div (E) Est. 5-Yr Growth P/E (12/08E) P/E (12/09E) 12/07A EPS 12/08E Cur EPS 12/08E Prev EPS 12/09E Cur EPS 12/09E Prev EPS US$38.02–US$26.88 US$0.72 NA 10.9x 9.6x US$2.40 US$3.20 US$2.99 US$3.64 US$3.58
Investment Strategy
We rate Timken as a Buy (1H) with a $48 target price. We see Timken as an interesting value-oriented idea that also has key above average near-term growth opportunities and is underappreciated by the Street. Timken’s largest business segment, its Bearings and Power Transmission Group, and within that its Process Industries business, have above-average growth opportunities over the near term. Key products in TKR’s Bearings and Power Transmission Group (large bearings) can outgrow broader industrial economy next 12-months given they’ve been some of most supply constrained products in the industrial economy. New capacity soon on-stream positions TKR to play catch up. As well, TKR historically has underserved Asia but new capacity soon on-stream will help rectify that and TKR will become somewhat a “wind power play” as that business is build out. In addition to Street EPS estimates are far too low (we’re Street high for ‘08-’10), we also see an emerging cash flow story at Timken. Capex likely peaked for the foreseeable future in ’07, and operating cash flow improvement aided by reduced pension contributions. While the macroeconomic environment coming in better than feared can alone push the stock higher, the low multiples TKR currently trades at suggest not just macro concerns exist but high skepticism that management can improve operations. With the stock trading at depressed multiples across many valuation metrics, and our “glass half full” macro view, we’re very attracted to this very inexpensive option on management being able to improve operations even modestly. — July 21, 2008
Price Performance (RIC: TKR.N, BB: TKR US)
38
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Insights
Industry
Managed Care
Cycle Bottoming? — A Look at UnitedHealth (UNH) and WellPoint (WLP)
Charles Boorady
UNH Signals Cycle Bottoming; Buy, TP $35
Buy/High Risk Price (22 Jul 08) Target price Expected share price return Expected dividend yield Expected total return Market Cap 1H US$26.21 US$35.00 33.5% 0.1% 33.6% US$32,204M UNH Signaling Bottom of 3-year Down-Cycle May Be Approaching — Now in the 3rd & worst year of a commercial downcycle of rising loss ratios in 20062008, UNH is sending a more convincing signal that it will begin to raise prices at a rate sufficient to offset rising medical cost trends, a move we think will result in stable loss ratios in 2009 vs. 2008, consistent with monthly industry trends we track. UNH now assumes medical costs rise at an accelerated rate of 8% +/- 50bps vs. previous 7.5% +/-50bps, while industry trends appear stable. Too early to call a cycle bottom, but historically downcycles lasted 3-yrs. Stock valuations at 7.5x 2009E EPS reflect something worse. Our $35 PT for UNH is +34% based on historical trough P/E of ~10x our 2009E EPS. UNH Stock Rally Restrained by Anxiety — UNH is the first MCO to report 2Q08 earnings. Concern that other MCOs might cut guidance further this quarter prevented the stock from moving up to what we think is fair value of about $31-$32 or 10x forward EPS, the historical trough P/E. UNH 2Q08 EPS Above Pre-released Guidance; Much Lower Loss Ratio, Conservative 2008 Guidance — 2Q08 EPS $0.67 v. Guided $0.64-$0.66, Cons $0.65 ex-items (-47c lawsuit settlements, -2c severance, +9c sale proceeds), & reit '08 guid. EPS $2.95-$3.05, cash flow ~$5bn. Variance Table Highlights: higher rev +1c; Inv Inc +1c (inc $50mn cap gains vs. our $0 est); MLR +10c offset by higher SG&A -10c; lower tax rate +1c; lower shr ct +1c; Cash flows from ops $600mn v. our $724mn est v. $1.7bn in 2Q07 (from lower earnings, timing of ~$700mn in tax pmts & return of $170mn in retained deposits); DCP 53 v. 51 1Q08 & 55 2Q07, zero prior period reserves vs. $110mn 2Q07. UNH's 2Q08 adjusted EPS of $0.67 was above the Street estimate of $0.65 and our estimate of $0.64. This result excludes a pre-tax operating cost charge of $922mn (-47c/share after-tax) for settlement of two class action lawsuits related to the company's historical stock option practices and related legal costs, a $46mn pre-tax operating cost charge (-2c/share after-tax) for employee severance related to operating cost reduction initiatives and other items, partially offset by a $185mn pre-tax reduction in 2Q operating costs (+9c/share after-tax) for proceeds from the sale of certain assets and membership in the individual Medicare Advantage business in Nevada in May 2008. Fine-tuning our 3Q08 and 4Q08 EPS. We now estimate a 3Q08 EPS of 74c (previously 75c) vs. new guidance "low to mid $0.70 per share range". We also estimate a 4Q08 EPS of 76c (previously 78c). Our full year 2008 estimate of $2.95 is unchanged. We are also maintaining our EPS estimates for 2009–11. — July 22, 2008
UNH Company Metrics
52-Week Range Div (E) Est. 5-Yr Growth P/E (12/08E) P/E (12/09E) 12/07A EPS 12/08E Cur EPS 12/08E Prev EPS 12/09E Cur EPS 12/09E Prev EPS US$58.99–US$22.16 US$0.03 10.7% 8.9x 8x US$3.50 US$2.95 NC US$3.30 NC
Price Performance (RIC: UNH.N, BB: UNH US)
39
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
WLP: Cycle Bottoming? 2Q $1.44 Beat Consensus $1.36 on Lower Loss Ratio
Buy/High Risk Price (22 Jul 08) Target price Expected share price return Expected dividend yield Expected total return Market Cap 1H US$48.75 US$61.00 25.1% 0.0% 25.1% US$25,651M WLP 2nd Major Health Insurer to Beat 2Q08 $1.44 v. Cons $1.36 — Replay of UNH yesterday, Lower Medical Loss Ratio (MLR) of 83.3% v. our 83.9% was the key driver of EPS upside, directionally consistent with our last few monthly pricing & cost trend observations. Current P/E 8x 2009E EPS, 20% below historical (15-yr) trough 10x P/E, & 50% discount to S&P500, reflects concern over downside EPS risk with underwriting cycle in 3rd down yr. Results 2Q08 from 2 largest insurers UNH, WLP increase confidence consensus EPS can be met suggesting fair value of 10x forward EPS, +25%. Buy UNH, WLP, CVH. Guides $5.42-$5.57 v. Cons $5.48; prev. $5.42-$5.67 — Trimmed upperend on lower estimated enrollment now 35.1mn YE08 vs. prev 35.3mn est. at 1Q08, therefore FY Op revenue guided $61.9bn (prev $62.3bn). No surprise weak economy cuts into enrollment. MLR guidance unchanged at 83.3%-83.6%; SG&A 14.5% (prev 14.4%); op cash flow $3.0bn (prev $3.3bn). See Original Note for Variance Table — Enrollment as well as premium & fee revenue were in line with our estimates. Main variance was on medical loss ratio that came in much better at 83.3%, 60bps lower than our 83.9% est, +9c. SG&A 14.3% was slightly better than our 14.6% est, +4c. Lower shr count, +4c. Investment inc lower than our est (inc 3c/shr in realized losses vs. our 0c/shr est), -3c. Op cash flow $112mn, lower than our $421mn est. DCP 47.7, -0.4 day from 48.1 at end of 1Q08. Prior period reserve developments +$270mn better than our $213mn estimate. We rate the shares of WellPoint, Inc. Buy/ High Risk (1H). In addition to being the country's largest publicly traded commercial benefits company, WellPoint's BC and BCBS brands give the company marketing advantage and high local market share facilitates a cost advantage — both key success factors in a thinmargin, competitive business. In the long run, despite the recent challenging regulatory environment for Blues conversion, we expect WellPoint to continue with its acquisition strategy, while leveraging integration synergies from prior acquisitions to contribute to margin expansion and top-line growth. We expect WellPoint to have average 10% EPS organic growth, driven by organic enrollment growth, market share gain, and price increases. WellPoint also wholly owns a pharmacy benefit manager, which has, historically, almost exclusively served its own health plan members. — July 23, 2008
WLP Company Metrics
52-Week Range Div (E) Est. 5-Yr Growth P/E (12/08E) P/E (12/09E) 12/07A EPS 12/08E Cur EPS 12/08E Prev EPS 12/09E Cur EPS 12/09E Prev EPS US$89.72–US$43.23 Nil 10.3% 9x 8.1x US$5.56 US$5.40 NC US$6.00 NC
Price Performance (RIC: WLP.N, BB: WLP US)
40
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Insights
Brokers & Asset Managers
Merrill Lynch & Co. Inc. (MER)
Assets Sold, Risk Down, Book Value Up, No Dilutive Raise
Prashant A. Bhatia, CFA
Buy/Medium Risk Price (17 Jul 08) Target price Expected share price return Expected dividend yield Expected total return Market Cap
1M US$30.73 US$65.00 111.5% 4.6% 116.1% US$30,201M
MER reported 2Q08 EPS of -$4.95 vs our estimate of -$3.95 (consensus $1.91) — Ex-losses related to legacy assets, we estimate core annualized EPS of $5.00. Probability of a large dilutive common equity raise has declined significantly — No dilutive equity raise is around the corner as Merrill sold $7b+ in noncore assets (and was rewarded with $1b+ in appreciation by not selling BLK). Exposure to risky assets declined by $25b, core earnings ex-legacy positions was $5.00 annualized, book value grew slightly and management still has capital flexibility to sell more non core assets if necessary. Massive de-risking — Merrill exposure to residential mortgages, commercial real estate and leveraged lending fell by $25b. About $12b or roughly half of the reduction came from sales that were executed at or near where they were marked. In addition, $11b of exposure to ABS CDOs was eliminated. We estimate the remaining worst-case headwind from the $20b long ABS CDO exposure (currently 38 cents on the dollar) is a very manageable $4b — Furthermore, even including our worst case writedown estimate on the $16b short exposure, the core earnings generation would be able to offset most of any worst-case scenario decline (e.g. no equity capital raise necessary). Reiterate Buy as underlying earnings power remains intact — Merrill is trading at book value. We view the massive de-risking and de-leveraging as good catalysts to get the stock moving higher. While legacy asset exposure remains, it’s manageable.
MER Company Metrics
52-Week Range Div (E) Est. 5-Yr Growth P/E (12/08E) P/E (12/09E) 12/07A EPS 12/08E Cur EPS 12/08E Prev EPS 12/09E Cur EPS 12/09E Prev EPS US$82.70–US$24.69 US$1.60 NA NM 7x US$-10.73 US$-7.00 US$-6.00 US$4.40 NC
Price Performance (RIC: MER.N, BB: MER US)
Significant Progress in Reducing Legacy Exposures
Merrill orchestrated a $25b reduction in exposure to risky assets…Merrill’s exposure to residential mortgages, commercial real estate and leveraged lending declined by almost 25% during the quarter (Figure 1). Of the $25b, about $12b or roughly half of the total reduction came from sales that were executed at or near where they were marked. In addition, $11b of exposure to ABS CDO long/short positions was eliminated primarily through writedowns or valuation adjustments. For a detailed analysis on broker de-leveraging during 2Q08, see our 7/14/08 note: https://www.citigroupgeo.com/pdf/SNA21714.pdf ...while simultaneously growing proforma book value per share slightly…We estimate that despite the $4.65b of negative net income, Merrill achieved growth in book value through the sales of an investment and a letter of intention to sell an entity. Figure 2 shows our estimate of proforma book value per share on an if-converted basis is about $29.00 (vs. $28.93 at 1Q08 end). ...as management delivered an extremely efficient capital raise under very tough circumstances (and it still has plenty of flexibility)…Despite the tough marketplace to raise equity and the potential for significant dilution, the $8b raise was extremely efficient and very shareholder-friendly. We were also very
41
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
encouraged that management also indicated that there may be other small entities or non-core assets that should give management the flexibility to raise additional capital efficient without significantly diluting common shareholders. ...and kept its BlackRock stake which appreciated $1.2b yesterday alone. Also, Merrill opting to keep its BlackRock stake and extending its general distribution agreement with BlackRock is a positive. Merrill retained an investment that we estimate generates over $500m in revenue for Merrill (with little associated expense). Further, the strategic partnership has the potential to be valuable.
Figure 1. Merrill Meaningfully Reduced Risk Exposures in 2Q08 ($b)
Exposure ($b) 1Q08 2Q08 ABS CDO long positions ABS CDO short positions US residential subprime US Alt-A residential Non-US residential mortgage Bank securities portfolio Commercial real estate Leveraged lending Total 26.3 19.9 19.8 15.6 1.4 3.2 8.8 19.8 1 1.5 7.4 18 Decline Amt % ($b) Change -6.4 -24% -4.2 -0.4 -1.6 -1.3 -1.8 -3.1 -6.7 -25.6 -21% -29% -51% -15% -9% -17% -47% -23%
The Long and Short of It
The most challenging exposure that Merrill has is its gross long and gross short exposure to US ABS CDOs (we no longer consider net exposure meaningful). While the net exposure is $4.5b, we no longer consider that meaningful to understand downside risk. Instead, we prefer to look at the gross long and short exposure separately since a large portion of the hedging strategy has been ineffective (primarily driven by the financial deterioration of certain counterparties). While it is extremely difficult to value these exposures, we attempt to identify worst-case type scenarios to better understand potential worst-case loss exposure going forward. Merrill has $19.9b of long ABS COD exposure and $15.6b of short exposure. We estimate worst-case scenario losses (not our expected scenario) could be about $4b, or a fraction of the total $20b long exposure…We’re not estimating that Merrill will generate a loss going forward, but rather trying to come up with a stress scenario to help quantify how manageable a downside scenario would be. Our estimate of Merrill’s long CDO of $19.9b is marked at about 38 cents on the dollar. We arrive at this by dividing the current long exposure of $19.9b vs. the original long exposure of $53b back in 2Q07. We arrive at the $0.30 intrinsic value based on discussions with industry contacts that indicate a vulture bid may be available in the 10 cents on the dollar range for these types of assets. Assuming an unlevered required rate of return to be at least 200% for these risky assets, it implies a $0.30 intrinsic value derived from the vulture bid of $0.10. ...and we estimate worst-case scenario losses of just under $5b on the short positions related to ABS CDOs, a fraction of the $15.6b total exposure. We estimate the $15.6b gross short ABS CDO exposure at 2Q08 is comprised of $6b with large high-quality counterparties (e.g. non-monoline entities), $4.7b primarily with MBIA, and $4.9b with A or below rated monoline counterparties. Our worst-case loss assumption assumes 100% of the lower-rated monolines end up being restructured in a way that the entities are not able to make future insurance payments resulting in a total loss for Merrill. We also assume in this scenario MBIA will even in runoff be able to make its payments virtually in full. ...and even if these unlikely scenarios were to come to fruition, losses would be gradually realized as the market deteriorated over several quarters. In turn, this would give Merrill time to earn through some of the losses and maybe deleverage even further if necessary. With the ability to generate core pre-tax earnings of $2b in a tough environment, as long as losses were spread out over time, Merrill could absorb and/or partially offset these losses through earnings. — July 18, 2008
18 14.9 14.2 7.5 112 85.9
Source: Company reports and CIR estimates
Figure 2. We Estimate Merrill’s Book Value Grew Despite Losses ($b)
2Q08 Common equity (as adjusted) Equity received from sales (post 2Q08): Bloomberg sale (pre-tax) FDS sale (75% of entity) Less: FDS cost basis (75% of entry) Total pre-tax proceeds Less: taxes (30% tax rate) After-tax equity proceeds Proforma common equity Adjusted share count Proforma book value 27,700 —-> as of
6/27/08
4,425 2,625 —-> enterprise
value of $3.5b
-375 —-> carried at
$500m
6,675 -2,003 4,673 32,373 1,111.30 $29.13 —> vs $28.93
at 1Q08
Source: Citi Investment Research estimates
42
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Insights
Industry
Semiconductors / Specialty Semiconductors
Recent Earnings and Industry Updates
Glen Yeung / Craig A. Ellis
Semiconductors
Glen Yeung
Semi Beat: SOXX 330: Support Level?
SOXX 330 Is Support — Over the past 5 years the SOXX has found support on several occasions at approximately 330. While by no means are we technicians, we are cognizant of the importance this level can make in some investment decisions. Based on near-term fundamentals, cyclical position, and trough valuations, we believe 330 will again form a support level for the group, implying downside is limited to ~10% from current levels. NT Fundamentals Supportive — Recent earnings results for chipmakers have been surprisingly solid. While chipmakers are still prone to macro risk, notably from weakening European economies, we suspect that the tenor of on-going 2Q08 earnings will be sufficient to sustain the 330 support level. Semi-Cycle within Economic Cycle — We reiterate our view that chipmakers are managing the “semiconductor” cycle within the “economic” cycle well. Inventories remain well controlled, particularly in light of initial 2Q08 earnings reports, and are markedly different from the last period when the SOXX broke 330 support (2001–02). We believe this cyclical management differentiates the current cycle from the 2001–02 period.
We assert that a combination of SOXX 330 and trough valuation (for any given name) ought to embolden investors.
Conclusion — We assert that a combination of SOXX 330 and trough valuation (for any given name) ought to embolden investors. We are not ignorant of the risks in the current macro-environment, nor are we unaware of the potential for individual ideas to break through trough valuations. We therefore remain selective, focusing on names where longer-term trends are positive. We continue to favor TXN (TXN.N; US$24.72; 1M), ALTR (ALTR.O; US$21.50; 1H), INTC (INTC.O; US$22.25; 1M). — July 20, 2008
Texas Instruments Inc. (TXN): Miss/Miss Is Disappointing but Creates an Uncommon Opportunity
Buy/Medium Risk Price (21 Jul 08) Target price from US$39.00 Expected share price return Expected dividend yield Expected total return Market Cap 1M US$28.52 US$36.00 26.2% 1.4% 27.6% US$37,724M Reports/Guides Below — TI reported 2Q08 results and guided 3Q08 below current consensus for both revenues and earnings. We are lowering our 2008/2009 revenues to $13.5B/$14.5B from $13.8B/$14.9B and EPS to $1.81/$1.90 from $1.99/$2.24. We lower our price target to $36 from $39. Cites Distributors — Although wireless was a source of weakness, wireless declines of 2% were not dramatically outside of our expectations. However, weakness in TI's distribution-based business was the largest surprise, falling in the month of June as distributors chose to reduce inventories. Given its
43
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
broad-based nature (according to TI), we view this as an industry issue that is apt to taint forthcoming semiconductor earnings. Downside Is Limited — We have conducted an analysis of TI's gross margins and conclude that worst case downside is 50%. When incorporating this into a scenario analysis of revenue outcomes, it leads us to believe downside is limited in TXN. Meanwhile, we do not view TI's long-term model as broken, and believe upside earnings potential exists to $2.25 should TI achieve its operating targets. An Uncommon Opportunity — While the short-term outlook for TI has been worse than our fears, the shares have fallen precipitously. Our analysis suggests downside is limited and upside is now uncommonly attractive. We reiterate our Buy rating on the back of this near-term earnings shortfall. — July 20, 2008
Downgrading Memory Names to Hold
Figure 1. Rating and Target Price Changes
Price Ticker 21-Jul MU US$5.66 QI US$2.76 SPSN US$2.28 Rating Target Price Old New Old New 1S 2S US$10.00 US$6.50 1S 2S US$6.00 US$2.50 1S 2S US$5.00 US$3.00
Downgrading Memory Names to Hold — We are downgrading the shares of 3 memory companies: Micron, Qimonda, and Spansion. Our positive rating on these shares, based largely on valuation, has simply been wrong and with renewed risks forming in the NAND market, compounded by a highly questionable macro-environment, we downgrade the shares here, despite the very low valuations. Our rating on Micron goes to 2S from 1S, Qimonda to 2S from 1S and Spansion to 2S from 1S. NAND Weakness — While it is no surprise that NAND pricing is weak, results from Sandisk add incremental concern. We note that Sandisk reported a 15% increase in on-hand inventories and indicated channel inventories have increased to 8–9 weeks. This creates risk of further NAND pricing degradation throughout CY08 and 1H09. Comprising 35% of Micron sales, such weakness cannot be ignored, leading us to lower our Micron estimates. Our Micron price target falls to $6.50, driving our rating to 2S. Impacting NOR Demand — We expect NAND price weakness to negatively impact demand for NOR as a NAND/DRAM combination presents an increasingly attractive alternative. With specialty DRAM prices also suffering (as noted in Micron's last earnings results and reflected in our QI estimate revisions), this is even more the case. We note that in 1Q07, weak NAND pricing negatively impacted Spansion's results; we fear the same result in 3Q08 and consequently reduce our estimates. Our Spansion price target falls to $3, driving our rating to 2S. QI Hampered by Specialty DRAM — Recent weakness in specialty DRAM pricing (comprising 50% of Qimonda's sales) lead us to lower estimates for Qimonda. This is exacerbated by a worsening currency condition (we increase our €/$ exchange assumption to 1.58 from 1.50 through CY08 (reflecting Citi's current view) that lowers EPS by €0.18. As we do so, our cash balances for Qimonda fall precariously low by F2Q09 (Mar-09), making the likelihood of a dilutive liquidity event high. Recognizing this, we lower our price target to $2.50, substantiating a 2S rating. — July 22, 2008
Source: Citi Investment Research
Figure 2. EPS Estimate Changes
Current Year Old New US$-1.82 US$-1.82 US$-6.63 US$-7.58 US$-2.31 US$-2.54 Next Year Estimates Old New US$-0.40 US$-0.75 US$-2.40 US$-3.59 US$-0.82 US$-1.30
Ticker MU QI SPSN
Source: Citi Investment Research
Limited Case for NT Upside: In the context of a risky macro environment, we have been emphasizing that investors gravitate toward quality names with solid longer-term stories. While we have some optimism over longer-term supply conditions (given reductions in bit growth assumptions by Sandisk and expected by Samsung), we believe near-term demand conditions present considerable overhang.
44
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Specialty Semiconductors
Craig A. Ellis
Specialty Semi Week #1 Results Update: Final Three Innings of C08’s Up-Cycle Looking More Probable
Escaping a 7th Inning Rain-Out? — On June 19th we cautioned stocks were in the 6 th inning of an up-cycle, reducing estimates and ratings selectively. While pre-earnings macro concerns and estimate risks threatened and ugly 2H08, prospects for a second leg up may be emerging from: 1) favorable risk/reward after a 23% May-July tumble, 2) early chip reporting and est revisions better than feared, 3) helpful hardware and handset data points, 4) a brief reversal in oil’s surge, and 5) time, since better chip order seasonality should now be <1.5 months away. Our favorite names are ONNN (ONNN.O; US$9.11; 1S) and MRVL (MRVL.O; US$15.46; 1H), off 10.7% and 13.9% off from YTD highs. After the Fall: Huge Pull-Back Mitigates Downside Risk — From mid-May to July 14 our group pulled back 23%: a) discounting 81% and 66% of a 3/4cycle average plunge, b) pushing F12M P/E and EV/S multiples below C07 lows to 13.9x and 4.1x and near troughs, and thus, c) limiting downside barring EPS cuts. While not precluding further declines if co-specifics erode (especially margins), the set up is favorable for a rebound in stocks with strong financials, compelling catalysts, and benign valuation if sector fundy’s prove better than feared as we may be seeing. And Reporting Upsides Worst Fears — While early: a) 87.5% of week-1 chip co’s have beat 2Q rev estimates, 62.5% have beat EPS, b) PC data points have helped (2Q unit ships better at +15% y/y, 3Q NB data pts improving), and c) handsets data points are a relief overall (NOK better, China orders rebounding, though SNE weak). Help in Abating Macro Pressure? — While potentially temporal the week’s 12% oil price decline clearly helped tech stock performance. Given consumer sentiment and electronics spending implication, this bears watching through 2H08. Seasonal Negative Soon a Positive — Despite poor June–Aug order seasonality, mgt sentiment has been surprisingly confident. We attribute: a) lean inventory, b) modest late-2Q order weakness, and c) manageable pricing (ex NAND). Back to school and holiday build tailwinds should be a “+” for management tone, stocks in Sept. Risks — a) macro deceleration (US, Euro, China), b) BTS consumption intensity, and c) finished product and chip inventory risks in late08/early 09. Data Points Support ONNN, MRVL — ONNN: a) contra-seasonal 2H08 industrials strength (FCS) boosts 23% of sales, b) PCs are 20% sales, and c) 2Q08’s outlook was reaffirmed on 7/17. MRVL: a) PC’s are ~25% of sales (HDD’s), and b) solid 2H08 Comms chip orders are expected at SWKS, ALTR (25% of sales) — July 20, 2008
45
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
SanDisk Corp. (SNDK): Downgrade to Sell; No Clear Path to Profitability
Sell/Speculative from Hold/High Risk Price (21 Jul 08) Target price from US$20.00 Expected share price return Expected dividend yield Expected total return Market Cap 3S US$15.60 US$14.00 -10.3% 0.0% -10.3% US$3,506M Downgrade to Sell — We had warned NAND fundamentals were eroding sharply since June 19th but the outlook miss was far worse than expected. We now see: 1) A huge profitability hole as C08/09 EPS plunge to -$0.15/$0.30 from $1.23/$1.29, 2) an inventory overhang through 4Q08, 3) falling cash flow vs. capex needs in C09/10, and 5) stock headwinds in late-4Q08 as industry seasonality rolls over. Target price to $14 for downside of 10%. 2Q08 Results a Huge Miss — Revenues missed big (-4% to $816.0M; Street $912.0M) as did product gross margin (5.7% vs. 14%–18% guide) so after in-line opex ($224.5M), PF EPS were -$0.10, far below the Street’s $0.14. As bad, on-hand inventory jumped 15% (to 112 days), and channel inventory rose to 8–9 weeks, each material overhangs to 2H08 gross margin improvement. 3Q08 Outlook Worse — A $800M revenue midpoint (-2% q/q; 20% below Street) allows for aggressive pricing (CIR: -25%) to start clearing excess inventory. On 0% product gross margin, we now model -$0.22 EPS (from $0.31, Street $0.41). On hand inventory expected to build further in 3Q08, a 4Q08 risk. — July 22, 2008
Street EPS to Get Crushed; Stock Sponsorship the Casualty: Street EPS should fall toward CIR’s new estimates and some downgrades are likely (9 Buy, 10 Hold, 1 Sell). Stalwart Bulls will argue bad news is priced in (stock –13% AMC), but history argues otherwise when 1Q’s ugly seasonality lies ahead.
Broadcom Corp. (BRCM): C2Q08 Results First Take — Sharp, High Quality 2Q08 Upside
Buy/High Risk Price (22 Jul 08) Target price Expected share price return Expected dividend yield Expected total return Market Cap 1H 2Q08 Results Sharply Above — Revenues jumped 16.3% to $1.20B, beating consensus/CIR of $1.10B (+6.6%) while product gross margin increased by 30 US$27.11 bps to 53.3% (CIR 52.5%). Opex of $398M were higher than our model but 170 US$36.00 bps lower as a percent of sales (33.2% of sales vs 34.9% est) for op margins of 32.8% 21.5% (CIR 19.1%) suggesting PF EPS of $0.50, well above CIR/Street 0.0% $0.37/$0.36. On a GAAP basis, EPS of $0.25 nearly doubled CIR’s $0.13 (First 32.8% Call still pro forma). Inventory +15.6% in dollars, flat in days at 42 so benign US$12,102M versus a trailing 2-year range of 40.8-56.7. 3Q08 Outlook on Call — There was no guidance provided in the press release. CIR/Street models 4.7% revenue growth to $1.152B (150 bps below seasonality), and $0.39/$0.37 in PF EPS. As we think BRCM is likely to guide for revenue growth, meaningful upside to Street appears likely. Stock Strategy: We have been constructive on BRCM shares in C08. Positive secular drivers are numerous (WLAN, Bluetooth, Digital TV and GPS) and product cycle leverage is positive (exposure to iPhone, home router solutions, and 3G phones). Further we believe expense controls under CFO Eric Brandt are becoming increasingly well entrenched, a positive for margin and earnings leverage ahead. — July 22, 2008
46
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Top Picks Live! — Focus
Apple, Gamestop, Google, Pactiv
Richard Gardner / Tony Wible, CFA / Mark S. Mahaney / Timothy Thein, CFA
Apple Inc. (AAPL.O; US$166.29; 1H) — Great Quarter, Conservative Guidance; Reiterate Buy
Richard Gardner Quick Call — While you would not guess it based on the downdraft in AAPL shares in the after-market, the company reported stellar 2CQ results. The shares are down on conservative 3CQ guidance, conservative FY09 gross margin guidance and management's refusal to comment on Steve Jobs’s health. We consider the pullback a buying opportunity and reiterate our Buy rating. No Signs of Demand Deterioration — Apple reported impressive 41% yoy growth in PC shipments and better-than-seasonal iPod shipments, yielding total revenue growth of 38% yoy, 4% above management's perennially conservative guidance and 1% above consensus. Growth was especially strong in flat panel iMac, shipments of which appear to have grown close to 80% yoy. Conservative September Quarter Guidance — As in the prior two years, management guided revenue up just 5% qoq in 3CQ versus 11%-15% growth in the previous two 3CQs. Given significant product refreshes in notebooks and iPods in August/September and strong initial demand for iPhone 3G, management's 3CQ guidance seems overly conservative. We are actually raising our 3CQ revenue estimate from $8.2 billion to $8.3 billion (+11% qoq). Conservative FY09 Gross Margin Guidance — Management guided FY09 gross margin to “about 30%” versus consensus of 32-33%. Again, this seems overly conservative given the impending mix shift toward highermargin iPhones, which should boost corporate gross margin by approximately 100bp annually. — July 22, 2008
Gamestop Corp. (GME.N; US$45.25; 1H) — E3 Review — Extending the Gaming Cycle
Tony Wible, CFA Highlights — The overarching theme out of E3 was the emphasis on titles for every age group and genre. Casual gaming and social interaction were on display, with many new co-op titles, music game sequels, and new peripherals. This diverse backlog should expand the gaming demographic base, leading to a larger gaming cycle. A Flurry of New Titles — The increasing backlog of new titles should quell concerns and reassure investors that title visibility looks strong for 2H08 and 2009. Next generation titles are starting to shine (should spur more seventh generation adoption) while our discussions with developers lead us to
47
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
believe they will look for returns on their seventh generation software engine investments by developing for these platforms for many years to come. No Signs of Slowing Down — NPD data, combined with our conversations with developers, leave us more confident of near-term growth, despite the macroeconomic environment. God of War 3, Final Fantasy 13 for the 360, Assassins Creed 2, Bioshock 2, Animal Crossing, GTA for the DS, Halo (unnamed) and other title announcements add to 2009 visibility. Future console price cuts, aided by these new software releases, should prolong the gaming cycle as software growth feeds off higher hardware penetration. Reiterate Buy — We maintain our Buy rating and $66 target on: 1) title lineup strength; 2) potential for additional hardware cuts later this year; 3) PS3 momentum; and 4) growth in casual and social gaming. — July 20, 2008
Google Inc. (GOOG.O; US$492.75; 1H) — Q2 08 Results OK, But Keeping Focus on ’09 and Product Cycles
Mark S. Mahaney Versus Our Cheat Sheet, GOOG Reported a Neutral Q2 — Google posted $3.89 billion in net revenue and $4.63 in non-GAAP EPS (approximately $4.80 using our assumed interest income) versus our/Street estimates of $3.82 billion/$3.87 billion and $4.73/$4.74, respectively. Quarter-overquarter net revenue growth of 5.2% was OK, but high-ends expected 5.5%+. Fundamental Trends Were Reasonable — Year-over-year organic revenue growth decelerated to 34% from 40% in Q1 and 46% in Q4. Operating margin of 47.5% was down 190 bps, the lowest year-over-year decline in three years. Operating income growth accelerated to 37% year over year versus Q1’s 30%. ’08 Revenue and Operating Income Estimates Unchanged, But EPS Lowered Owing to Interest Income — ’08 non-GAAP EPS was decreased from $19.98 to $19.43. We have reduced our price target from $630 to $610 — 30X ’09 GAAP EPS of $20.26/26X ’09 non-GAAP of $23.69 (excluding stock comp). Reiterate Buy and Top Pick — Q2 results and the weakening macro environment (which is negatively affecting GOOG) don’t provide reasons to Buy. But despite the macro environment, continued sizable investments, and fewer opportunities for excess market share gains, GOOG’s organic bottom-line growth will likely be close to 30% in ’08. This sets up ’09 fundamentals to begin to benefit from: 1) a potentially improved macro environment; 2) potential opex leverage from “normalized” personnel/capex spend; and 3) material new product cycles. — July 18, 2008
Pactiv Corp. (PTV.N; US$21.28; 1M) — Spreads Squeezed in 3Q; Stock Already Discounts Guidance Cut
Timothy Thein. CFA
48
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Updated Guidance to Reflect Price/Cost Mismatch — Based on the current resin/energy cost environment, we see the greatest downward pressure on PTV’s spreads (and guidance) in 3Q08. However, with prices rising across the board, we see spreads beginning to improve in 4Q08. With ’08 consensus already $0.17 per share below the midpoint of the existing range and PTV near its all-time low valuation, lowered guidance is already factored in. Resin Costs Squeezing 3Q Hard — After rising 5 cents per pound (cpp) in June, additional price hikes totaling~15 cpp have been nominated for July/August for both polystyrene and polyethylene (PTV’s largest grades). Assuming two-thirds of the increases are implemented (as CMAI projects), this would equate to sequential cost increases of ~$29 million (roughly $0.14 per share) on these resins alone. Foodservice Pricing Initiatives — PTV has announced two 8% price hikes (June and July) on its non-contract business. Coupled with similar lags (~90 days) on price escalators, this suggests a big ramp in pricing starting in late 3Q/4Q 08. Growth in Prairie Capacity/Contract Wins — Because of contract wins and modest share gains (due to Prairie) we see PTV’s Foodservice segment faring better than the industry. Our research indicates relevant PS shipments are down ~6% year-to-date. Consumer Price Hikes: Replay of ’05? — PTV last took midyear Consumer price hikes in late ’05, which helped set the stage for huge margin expansion in ‘06. We could see a similar improvement in ’09 should CIR’s call that the ethylene cycle will soon begin to roll over prove correct. Maintain Buy on PTV. — July 22, 2008
49
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Top Picks Live!: Listing by Sector Grouping/Industry – as of July 22, 2008
Industry Analyst Company Name Symbol Inception Date Inception Date Price* Current Price Rating Target Exp. Share Price Return Exp. Div Yield ETR Footnote
Consumer Apparel/Footwear/Textiles Apparel/Footwear/Textiles Broadline Retailers Small Cap Pick Leisure Products - (Small Cap) Household/Personal Care Products Small Cap Pick Food Products / Producers Tobacco Energy Exploration & Production Financial Brokers & Asset Managers Insurance Small Cap Pick Insurance Insuarance - Non-Life Health Care Services Biotechnology Managed Care / Medical Services Medical Supplies & Technology Medical Supplies & Technology Small Cap Pick Industrials Aeropsace & Defense Multi-Industry Materials Chemicals Small Cap Pick (Top Sell) Basic Materials Containers & Packaging Paper & Forest Products Small Cap Pick Media Cable, Satellite, & Entertainment Small Cap Pick Internet Publishing & Advertising MLPs, GPs, and Royalty Trust Partnerships Master Limited Partnerships (small cap) Royalty Trust Partnerships Real Estate Investment Trusts (REITs) REITs Top Sell Technology Computer Services & IT Consulting Business Services Electronic Payments and Info Services Small Cap Pick Electronics Manufacturing Services PCs / Server & Enterprise Hardware Semiconductor Equipment (Small cap) Semiconductors Semiconductors - Specialty (Small cap) Software Telecommunications Wireless & Wireline Services Small Cap Pick Telecommunications Services (Small Cap) Utilities Electric Utilities Integrated Natural Gas & Gas Utilities Closed End Funds Closed End Funds - Equity Income Closed End Funds - Taxable Closed End Funds - Tax-Free
Kate McShane Kate McShane Deborah Weinswig Greg Badishkanian Wendy Nicholson David Driscoll Adam Spielman Gil Yang Prashant Bhatia Keith Walsh Colin Devine Joshua Shanker Lucy Lu Charles Boorady Amit Bhalla Matthew Dodds
Nike Inc VF Corp Wal-Mart Stores Inc Saks Inc Polaris Industries Avon Products Inc Alberto-Culver Co ConAgra Foods Inc Philip Morris International Pioneer Natural Resources Co Merrill Lynch & Co Inc Aon Corp National Financial Partners Corp Principal Financial Group Inc PartnerRe Ltd United Therapeutics Corp Coventry Health Care Inc Hologic Inc Covidien Ltd Cynosure Inc Raytheon Co Honeywell International Inc Albemarle Corp NOVA Chemicals Corp Terra Industries Inc Pactiv Corp International Paper Co AbitibiBowater Inc Time Warner Inc Mediacom Communications Corp Google Inc McGraw-Hill Inc
NKE VFC WMT SKS PII AVP ACV CAG PM PXD MER AOC NFP PFG PRE UTHR CVH HOLX COV CYNO RTN HON ALB NCX TRA PTV IP ABH TWX MCCC GOOG MHP
3-Jan-2008 23-Jun-2008 3-Jan-2008 3-Jan-2008 14-Jul-2008 3-Jan-2008 29-Jan-2008 3-Jan-2008 25-Jun-2008 11-Apr-2008 3-Jan-2008 3-Jan-2008 8-May-2008 3-Jan-2008 30-May-2008 3-Jan-2008 26-Jun-2008 3-Jan-2008 10-Jan-2008 3-Jan-2008 3-Jan-2008 3-Jan-2008 3-Jan-2008 8-Jul-2008 16-Jun-2008 3-Jan-2008 9-Apr-2008 3-Jan-2008 30-Jun-2008 3-Jan-2008 30-Jun-2008 3-Jan-2008 3-Jan-2008 10-Jun-2008 3-Jan-2008 3-Jan-2008 3-Jan-2008 8-Jul-2008 23-Apr-2008 16-May-2008 3-Jan-2008 11-Feb-2008 9-Jun-2008 19-May-2008 3-Jan-2008 19-Jun-2008 3-Jan-2008 3-Jan-2008 3-Jan-2008 1-May-2008 3-Jan-2008 3-Jan-2008 3-Jan-2008 3-Jan-2008
$63.28 $70.80 $46.72 $20.27 $41.00 $39.44 $25.70 $23.31 $51.53 $53.62 $52.83 $46.68 $24.57 $68.20 $73.52 $99.04 $31.20 $34.11 $44.38 $25.92 $60.10 $59.98 $40.70 $24.29 $51.25 $25.99 $29.21 $20.75 $14.59 $5.18 $532.47 $42.60 $54.27 $20.76 $86.21 $61.95 $55.38 $28.58 $55.21 $3.25 $44.36 $128.01 $22.41 $32.20 $8.50 $17.00 $48.80 $99.02 $19.84 $76.32 $61.55 $26.16 $10.43 $14.05
$58.67 $74.63 $59.06 $11.12 $45.30 $36.34 $25.36 $20.95 $52.05 $63.39 $34.18 $46.16 $19.77 $40.93 $66.09 $105.10 $31.91 $23.82 $50.84 $22.35 $56.77 $52.32 $36.85 $26.43 $48.83 $22.06 $24.01 $8.77 $14.51 $5.77 $477.11 $39.05 $44.39 $19.84 $92.31 $52.22 $48.63 $29.25 $43.44 $2.59 $49.35 $162.02 $18.50 $24.35 $9.02 $16.48 $47.02 $90.25 $14.91 $77.38 $54.89 $20.95 $10.75 $13.45
1L 1M 1L 1H 1M 1M 1M 1M 1M 1H 1M 1M 1H 1L 1M 1H 1H 1M 1H 1H 1M 1M 1M 3H 1H 1M 1H 1S 1M 1S 1H 1M 1M 1H 1H 3H 1M 1H 1H 1S 1M 1H 1H 1M 1S 1H 1H 1S 1S 1M 1M 1M 1M 1H
$78 $97 $67 $17 $49 $55 $30 $32 $62 $100 $65 $55 $30 $70 $89 $130 $42 $35 $58 $38 $75 $70 $47 $21 $62 $30 $41 $28 $25 $11 $610 $51 $66 $28 $107 $52 $67 $46 $66 $9 $55 $287 $30 $36 $14 $24 $62 $120 $25 $86 $69 n/a n/a n/a
33% 30% 13% 53% 8% 51% 18% 53% 19% 58% 90% 19% 52% 71% 35% 24% 32% 47% 14% 70% 32% 34% 28% -21% 27% 36% 71% 219% 72% 91% 28% 31% 49% 41% 16% 0% 38% 57% 52% 228% 11% 77% 62% 48% 55% 46% 32% 33% 68% 11% 26% n/a n/a n/a
1% 3% 2% 0% 3% 2% 1% 4% 3% 0% 4% 1% 4% 2% 3% 0% 0% 0% 1% 0% 2% 2% 1% 1% 1% 0% 4% 0% 1% 0% 0% 2% 9% 10% 4% 4% 0% 0% 0% 0% 0% 0% 0% 2% 0% 0% 6% 0% 0% 3% 3% n/a n/a n/a
33% 32% 17% 50% 10% 54% 20% 56% 22% 60% 97% 23% 56% 75% 38% 24% 24% 47% 16% 67% 36% 37% 30% -20% 29% 28% 73% 208% 73% 85% 25% 33% 57% 52% 20% 2% 39% 56% 49% 214% 12% 76% 88% 47% 54% 44% 38% 31% 65% 16% 29% n/a n/a n/a
George Shapiro Jeffrey Sprague P.J. Juvekar Brian Yu Timothy Thein Chip Dillon
(1)
Jason Bazinet Mark Mahaney Catriona Fallon John Tysseland Richard Roy Michael Bilerman
NuStar Energy, L.P. NS Pioneer Southwest Energy Partners PSE Simon Property Group Inc Prologis Fiserv Inc Amdocs Ltd Gamestop Corp Blockbuster Inc Amphenol Corp Apple Inc FormFactor Inc Texas Instruments Inc ON Semiconductor Corp Nuance Communications Inc Embarq Corp Equinix Inc TW Telecom FirstEnergy Corp Sempra Energy SPG PLD FISV DOX GME BBI APH AAPL FORM TXN ONNN NUAN EQ EQIX TWTC FE SRE
(1)
Patrick Burton Ashwin Shirvaikar Tony Wible Jim Suva Rich Gardner Timothy Arcuri Glen Yeung Craig Ellis Brent Thill Michael Rollins Erin Schmitz Greg Gordon Faisel Khan Kathy Jones Frank Sileo Dennis Emanuel
Eaton Vance Tax Adv. Global Div Inc ETG Duff & Phelps Utility & Corp Bond T DUC Pimco Municipal Income Fund II PML
Ratings, Price Targets, Capital Appreciation, & Dividend Yields based on market close for July 22, 2008. *Inception date pricing based on opening prices.
Analyst Mark Mahaney removed VCLK on 7/17 Analyst Josh Attie removed IGT on 7/18
Notes: "Small-cap picks" designate optional s/c picks by the analyst (i.e., analyst also has a large-cap pick for sector). (1) Top Sell. (2) New Addition. Source: CIR
50
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
The Globaliser
July 16–21, 2008
Featuring Nokia: Bearish Sentiment Overdone
Bruce Rolph On…cracks in U.K. capitalism, Latin America’s metals & mining attractions, a tactical European equity shift, bullish in China coals, buying Vale, more global property pain, Aussie banks not immune, plus Nokia’s 44% upside potential. Economics & Currency
Sterling Weekly: Pain Is Not Over July 18, 2008 Michael Saunders
“The vice-like squeeze from the credit crunch and inflation pressures intensifies…the housing market remains in freefall, with the sharpest and most widespread declines since the 1930s…moreover, with the total first-year payments reaching a record 67% of annual income for first-time homebuyers, they seem to be becoming endangered…yet, early monetary policy easing is unlikely unless depression (not recession) threatens…in sum, the continued decline in property prices, plus feedback from the worsening economy to more bank losses and falling share prices, is starting to open up deeper cracks in the foundations of the current system of financial market-based capitalism.” Global Strategy
Latin America Strategy Chartbook: July 2008 July 16, 2008 Geoffrey Dennis
“Materials are, once again, the most attractive sector in Latin America, with their disproportionate 21% drop since the market’s peak…trading on a forward P/E of just 8.7x: Metals & Mining and Construction Materials is the most attractively valued at 8x, vs. Chemicals, the most expensive (at 31x)…by contrast, our work shows Energy is now the least attractive, trading at a 70% premium to its own history…Financials, meanwhile, are becoming compelling, but risks there are also rising, with deteriorating asset quality and slower loan growth given the ongoing rising rate cycle.” “Equities have been victims of a relentless sell-off with no respite: P/Es hit 10.2x last week, the lowest since 1984…from here, news flow looks to stay weak, and likely to deteriorate in the next six to 12 months…but previous bear markets suggest a relief may be close at hand…as do valuations and recent oil moves…so while we would not aggressively chase any such rally, it may be prudent to tactically reduce exposure to the short leverage trade… we raise Media from Underweight to Overweight…and send Utilities the other way… adding WPP and Vivendi to most favored stock list…removing EDF and E.On.” Materials
U.K./European Equity Strategy July 18, 2008 European Strategy Team
PRC Coal: Prices Steaming Ahead, Still Positive July 17, 2008 Thomas Wrigglesworth
“Coal is still one of the most crucial, cost-effective sources of energy for China and the world, so despite prevailing economic conditions, we remain positive on the outlook for prices and coal demand…indeed, with the recent unabated surge in spot prices serving to highlight the shortages and bottlenecks, we are raising our coal price forecasts by another 55% and 65% for '08 and '09…and we are raising our estimates, albeit not as much, heading into 1H08 earnings… best played via Buy-rated top picks Yanzhou and China Coal.” “Vale’s shares have lost over $30bn in market cap since its $11.5bn capital raise was first launched…a damaging exercise, yes, and absent M&A, we see the shares as range-bound until year-end…given: 1) M&A overhang; 2) low nickel prices; 3) cost pressures (operating & capex)…yet, we see good long-
Vale: Capital Raised…But at What Cost? July 17, 2008 Alex Hacking
51
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
term value in the stock at these levels…especially as its high-quality contract iron ore remains underpriced, and we expect another big price bump next year (+30% estimate)…given an expected 67% total return, we rate Vale Buy.” Financials
2Q08 Global Property Quarterly July 18, 2008 Global Property Team
“The pain is likely not over, even as the Global Property Index has dropped to its lowest level in over two years, down ~20% in the 1H…and forward multiples have dropped significantly, to 14x from 25x at the peak…given the weaker economic environment and constrained credit conditions…in addition, rising inflation around the world is putting upward pressure on interest rates…we forecast -5% to +5% returns over the next 12 months for global property stocks, after the 8% and 23% falls already seen in 2Q08 and YTD…but as valuations have converged between developed and emerging markets, we have also shifted our model weights in favor of a more company-specific, rather than regional, approach…our preference being for companies with strong balance sheets, recurring cash flows, and reasonable valuations, like Westfield Group, Unibail-Rodamco, Mitsui Fudosan, Simon Property, and Mitsubishi Estate… conversely, we recommend avoiding riskier small-cap stocks with large capital needs, as well as companies with AUM/FUM platforms.” “While Australian banks have been less impacted by the global credit unwind, they should not be immune…indeed, our analysis of the structured credit activities undertaken by the banking majors highlights two areas that concern us: counterparty risk via long CDS positions, with ANZ leading the way (~$23bn in exposures); and the provision of liquidity lines to conduit entities, where NAB is head and shoulders above peers (~$14bn in exposures)…as well, many economic indicators are now declining…and Australian credit growth is slowing rapidly (more than we forecast) as cost of living increases weigh on consumer and business confidence…so, we are cutting our estimates by as much as 12% and now expect sector EPS to fall in FY09…and we are lowering our target prices…and downgrading ANZ and NAB, the higher-risk banks, from Hold to Sell…WBC is our preferred pick, with CBA No. 2, yet both are just Hold rated.” Information Technology
Australian Banks: FY’09 EPS Growth — and Then There Was None July 21, 2008 Craig Williams
Nokia Oyj: New Products to Drive H2 Margin Momentum, Maintain Buy July 18, 2008 Sherief Bakr
“Bearish sentiment ahead of 2Q results proved exaggerated, as they were better than feared, demonstrating the resilience of Nokia's low & mid-range portfolio and ability to manage costs…looking ahead, fears over potential EU and emerging market weakness remain risks…but even if Nokia were to fail to grow earnings in '09 (unlikely, in our view) the stock is trading at an undemanding sub-10x multiple (ex-cash)…Buy Nokia for a 44% expected total return.”
Companies mentioned in this article: Australia and New Zealand Banking Group Ltd. (ANZ.AX; A$18.90; 3M), China Coal Energy (1898.HK; HK$15.00; 1L), Commonwealth Bank of Australia (CBA.AX; A$44.60; 2M), E.ON AG (EONG.DE; €119.60; 1M), Electricité de France (EDF.PA; €53.59; 1M), Mitsubishi Estate Co. Ltd. (8802.T; ¥2,565; 1M), Mitsui Fudosan Co. Ltd. (8801.T; ¥2,425; 1M), National Australia Bank Ltd. (NAB.AX; A$29.60; 3M), Nokia Corp. (NOK1V.HE; €16.95; 1H), Simon Property Group Inc. (SPG.N; US$92.31; 1H), Unibail-Rodamco Co. (UNBP.PA; €139.78; 1L), Vale (RIO.N; US$29.23; 1M), Vivendi (VIV.PA; €26.32; 1M), Westfield Group (WDC.AX; A$16.90; 1M), Westpac Banking Corp. (WBC.AX; A$22.00; 2M), WPP Group Plc (WPP.L; £4.70; 1M), Yanzhou Coal Mining Co. Ltd. (1171.HK; HK$15.00; 1L)
52
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Index of Companies
Allegheny Energy Inc. Allergan Altera Corp. Apple Inc. Bristol-Meyers Squibb Broadcom Corp. Caterpillar Inc. Discover Financial Services Eli Lilly Gamestop Corp. Google Inc. Intel Corp. 25 27 43 47 27 46 37 31 27 47 48 43 Int'l Business Machines Corp. Marathon Oil Corp. Marvell Technology Group Ltd. Merck Merrill Lynch & Co. Inc. Micron Technology, Inc. Omnicom Group Inc. ON Semiconductor Corp. Pactiv Corp. Pfizer Qimonda AG SanDisk Corp. 35 33 45 27 41 44 23 45 48 27 44 46 Schering-Plough Spansion Inc. Sunoco, Inc. Tesoro Corp. Texas Instruments Inc. Timken Co. UnitedHealth Valero Energy Corp. WellPoint Wyeth 27 44 33 33 43 37 39 33 39 27
53
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
US Portfolio Strategist
54
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
US Portfolio Strategist
55
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
US Portfolio Strategist
56
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Appendix A-1
Analyst Certification
Each research analyst(s) principally responsible for the preparation and content of all or any identified portion of this research report hereby certifies that, with respect to each issuer or security or any identified portion of the report with respect to an issuer or security that the research analyst covers in this research report, all of the views expressed in this research report accurately reflect their personal views about those issuer(s) or securities. Each research analyst(s) also certify that no part of their compensation was, is, or will be, directly or indirectly, related to the specific recommendation(s) or view(s) expressed by that research analyst in this research report.
IMPORTANT DISCLOSURES
Morgan Stanley Capital International Inc.’s (“MSCI”) MSCI Standard Index Series section of the MSCI Web Site contains documents regarding the MSCI Standard Index Series (collectively, along with any other information on this MSCI Standard Index Series section of the MSCI Web Site, “MSCI Standard Index Series Materials”). The MSCI Standard Index Series Materials have been prepared solely for informational purposes. None of the MSCI Standard Index Series Materials are a recommendation to participate in any particular trading strategy and none may be relied on as such. The user of the information contained in the MSCI Standard Index Series Materials assumes the entire risk of any use made of the information provided therein. Neither MSCI, its affiliates, nor any other party involved in making or compiling any of MSCI’s indices, makes any express or implied warranties or representations with respect to the information contained in the MSCI Standard Index Series Materials (or the results to be obtained by the use thereof), and MSCI, its affiliates, and any other party involved in making or compiling any of MSCI’s indices, hereby expressly disclaims all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of this information. Without limiting any of the foregoing, in no event shall MSCI, its affiliates, or any other party involved in making or compiling any of MSCI’s indices, have any liability relating to the MSCI Standard Index Series Materials for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages. The MSCI Standard Index Series Materials may not be reproduced or redisseminated in any form without prior written permission from MSCI. You may not use or permit use of any information in the MSCI Standard Index Series Materials to verify or correct data in any compilation of data or index. Also, you may not use or permit anyone else to use any information in the MSCI Standard Index Series Materials in connection with the writing, trading, marketing or promotion of any financial instruments or products or to create any indices (custom or otherwise).
Customers of the Firm in the United States can receive independent third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at http://www.smithbarney.com (for retail clients) or http://www.citigroupgeo.com (for institutional clients) or can call (866) 836-9542 to request a copy of this research. A member of Jonathan Rosenzweig's team holds a long position in the shares of Cisco Systems Inc and Intel Corporation. A director of Citi serves as a director and officer of Time Warner Inc. Citigroup Global Markets Inc. is acting as a financial advisor to Time Warner Inc. on the divestiture of Tegic Communications Inc., a wholly owned subsidiary of Time Warner fs AOL LLC, to Nuance Communications Inc. Citigroup Global Markets Inc. is serving as a lead financial adviser to Time Warner in the separation from Time Warner Cable Inc. A director of Citi serves as a director of Estee Lauder Companies Inc. A director of Citi serves as a director of IBM Corporation. A director of Citi serves as a director of Raytheon Company. A director of Citi serves as director of Hewlett Packard Co. Citi acted as financial advisor to Electronic Data Systems Corp. in the merger with Hewlett-Packard Company. An employee of Citigroup Global Markets Inc or its affiliates is a director of IHS Inc. A director of Citi serves as a director of IHS Inc. An employee of Citigroup Global Markets Inc. is a director of Wyeth. Citi is advising ProLogis (PLD.N) regarding their proposed acquisition of Macquarie ProLogis Trust (MPR.AX). Citigroup Global Markets Australia Pty Ltd is acting as Joint Lead Manager and Joint Bookrunner fo Westpac's (WBC.AX) stapled preference share offering. Citigroup Global Markets Inc is acting as adviser to Nokia in respect to the acquisition of Navteq Corp. The President and Chief Executive Officer of Nokia Corporation serves as a director on Citi's International Advisory Board. Citigroup Global Markets Inc. is acting as a financial advisor to Alltel Corporation, a portfolio company of TPG Capital and GS Capital Partners, in its proposed acquisition by Verizon Wireless, a joint venture of Verizon Communications and Vodafone. Citigroup Global Markets Inc. is acting as a financial advisor to Blackrock Inc. in its proposed acquisition of Quellos Group LLC. Citigroup Global Markets Inc. is acting as a joint bookrunner on Companhia Vale Do Rio Doce announced international offering. Citigroup Global Markets Inc. is acting as the joint book-running manager for the offering of common stock of Nuance Communications, Inc. Citigroup Global Markets Inc. served as financial adviser to Spansion Inc. in its proposed purchase of Saifun Semiconductors Ltd. Citigroup Global Markets Limited is acting as advisor to Saudi Oger Ltd in its potential sale of a minority stake in Oger Telecom to Vivendi Universal
57
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Citigroup Global Markets is acting as co-manager for Westfield Group's (WDC) $3 billion underwritten pro-rata entitlement offer of new securities in WDC. Citigroup Global Markets is advising the Commonwealth Bank of Australia on their proposed acquisition of IWL Limited (IWL.AX) The Chairman and Chief Executive Officer of International Paper serves as a director on Citi's International Advisory Board. The Chairman of Citi serves as a Non-Executive Director of Lilly (Eli). The Chairman of Citi serves as a Non-Executive Director of McGraw-Hill Inc. The Firm's Independent Consultant pursuant to the Global Research Analyst Settlement is a non-executive director of WPP Group Plc Citigroup Global Markets Inc. or its affiliates beneficially owns 1% or more of any class of common equity securities of AbitibiBowater Inc, American Express Co, ANZ Banking Group Ltd, Apple Inc, Broadcom Corporation, Caterpillar, Inc., Commonwealth Bank of Aust. Ltd, ConAgra Foods, Cynosure Inc, Equinix, Inc., Fannie Mae, FormFactor, Freddie Mac, Hewlett-Packard, Hologic Inc, Marriott International Inc., Merrill Lynch & Co., Micron Technology, Microsoft Corporation, Morgan Stanley, National Australia Bank Ltd, News Corp, Nova Chemical, PartnerRe Ltd., Roper Industries Inc, Saks Incorporated, SanDisk Corporation, Schering-Plough, Terra Industries Inc, Tesoro Corporation, United Therapeutics Corp, Urban Outfitters Inc., Vale, Westpac Banking Corporation and Yanzhou Coal Mining. This position reflects information available as of the prior business day. Within the past 12 months, Citigroup Global Markets Inc. or its affiliates has acted as manager or co-manager of an offering of securities of Aetna, Inc., Alexandria Real Estate Equities, American Express Co, Amphenol, ANZ Banking Group Ltd, Avon Products, Bear Stearns Cos Inc, BlackRock, Inc, Bristol-Myers Squibb, Caterpillar, Inc., China Coal Energy, Commonwealth Bank of Aust. Ltd, Coventry Health Care Inc, Covidien Ltd, E.ON, Eaton Corporation, EDF, Equinix, Inc., Fannie Mae, FirstEnergy Corporation, Freddie Mac, Hewlett-Packard, Hologic Inc, Honeywell International, International Business Machines, Kohl's Corporation, Marathon Oil Corp., Marriott International Inc., McGraw-Hill Inc, Merrill Lynch & Co., Metlife, Mitsubishi Estate, Morgan Stanley, National Australia Bank Ltd, Nuance Communications Inc, Nucor Corp, NuStar Energy, L.P., Pioneer Southwest Energy Partners L.P., ProLogis, Qimonda AG, Schering-Plough, Sempra Energy, Simon Property Group, Terex Corporation, Textron, Time Warner Inc, United Parcel Service Inc B, UnitedHealth Group, Vale, Valero Energy Corp, Verizon Communications Inc., VF Corp, Vivendi Universal, Wal-Mart Stores, Inc., Westfield Group, Westpac Banking Corporation, WPP Group plc and Yanzhou Coal Mining. Citigroup Global Markets Inc. or its affiliates has received compensation for investment banking services provided within the past 12 months from AbitibiBowater Inc, Aetna, Inc., Alberto-Culver Co, Alexandria Real Estate Equities, Allegheny Energy Inc, Allergan Inc, Allstate Corporation, Altera Corporation, American Express Co, Amphenol, ANZ Banking Group Ltd, Aon Corporation, Apple Inc, Arch Capital Group Ltd., Avon Products, Bear Stearns Cos Inc, BlackRock, Inc, Bristol-Myers Squibb, Caterpillar, Inc., China Coal Energy, Cisco Systems Inc, Commonwealth Bank of Aust. Ltd, ConAgra Foods, Coventry Health Care Inc, Covidien Ltd, Discover Financial Services, E.ON, Eastman Chemical, Eaton Corporation, EDF, Eli Lilly, Embarq Corporation, Equinix, Inc., Estee Lauder Companies Inc., Fannie Mae, FirstEnergy Corporation, Fiserv, Inc., Forest Oil Corporation, Freddie Mac, Gamestop Corp, Gaylord Entertainment, Genentech Inc, Google Inc, Health Net Inc, Hewlett-Packard, Hologic Inc, Honeywell International, IHS, Inc., Intel Corporation, International Business Machines, International Paper, Kohl's Corporation, Marathon Oil Corp., Marriott International Inc., McGraw-Hill Inc, Merck, Merrill Lynch & Co., Metlife, Micron Technology, Microsoft Corporation, Mitsubishi Estate, Mitsui Fudosan, Morgan Stanley, National Australia Bank Ltd, News Corp, Nike Inc, Nokia Corporation, Nuance Communications Inc, Nucor Corp, NuStar Energy, L.P., Occidental Petroleum Corp., Omnicom Group Inc, PartnerRe Ltd., Pfizer, Philip Morris International, Pioneer Natural Resources, Pioneer Southwest Energy Partners L.P., Principal Financial Group, Inc., ProLogis, Qimonda AG, Raytheon Company, Rockwell Collins, Saks Incorporated, Schering-Plough, Sempra Energy, Simon Property Group, Spansion Inc, Sunoco, Inc, Terex Corporation, Terra Industries Inc, Texas Instruments, Textron, The Charles Schwab Corporation, Time Warner Inc, TW Telecom, United Parcel Service Inc B, United Therapeutics Corp, UnitedHealth Group, Vale, Valeant Pharmaceuticals Holdings Inc., Valero Energy Corp, Varian Medical Systems Inc, Verizon Communications Inc., VF Corp, Vivendi Universal, Wal-Mart Stores, Inc., Waste Connections Inc., WellPoint, Inc., Westfield Group, Westpac Banking Corporation, Wisconsin Energy Corp, WPP Group plc and Wyeth. Citigroup Global Markets Inc. or its affiliates expects to receive or intends to seek, within the next three months, compensation for investment banking services from AbitibiBowater Inc, Aetna, Inc., Allstate Corporation, American Express Co, Amphenol, ANZ Banking Group Ltd, Aon Corporation, BlackRock, Inc, Bristol-Myers Squibb, Caterpillar, Inc., China Coal Energy, EDF, FirstEnergy Corporation, News Corp, Nokia Corporation, NuStar Energy, L.P., Pfizer, Principal Financial Group, Inc., Sempra Energy, Simon Property Group, Sunoco, Inc, Time Warner Inc, United Parcel Service Inc B, Valero Energy Corp, Verizon Communications Inc., Wal-Mart Stores, Inc., WellPoint, Inc., Westpac Banking Corporation and WPP Group plc. Citigroup Global Markets Inc. or an affiliate received compensation for products and services other than investment banking services from AbitibiBowater Inc, Aetna, Inc., Albemarle Corp, Alberto-Culver Co, Alexandria Real Estate Equities, Allegheny Energy Inc, Allergan Inc, Allstate Corporation, Altera Corporation, Amdocs Limited, American Express Co, Amphenol, ANZ Banking Group Ltd, Aon Corporation, Apple Inc, Arch Capital Group Ltd., Avon Products, Bear Stearns Cos Inc, BlackRock, Inc, Blockbuster Inc, BorgWarner, Inc., Bristol-Myers Squibb, Broadcom Corporation, Caterpillar, Inc., Celgene, China Coal Energy, Cisco Systems Inc, Commonwealth Bank of Aust. Ltd, ConAgra Foods, Coventry Health Care Inc, Covidien Ltd, Discover Financial Services, E.ON, Eastman Chemical, Eaton Corporation, EDF, Eli Lilly, Embarq Corporation, Equinix, Inc., Estee Lauder Companies Inc., Fannie Mae, FirstEnergy Corporation, Fiserv, Inc., Forest Oil Corporation, FormFactor, Freddie Mac, Gamestop Corp, Gaylord Entertainment, Genentech Inc, Google Inc, Health Net Inc, Hewlett-Packard, Hologic Inc, Honeywell International, IHS, Inc., Intel Corporation, International Business Machines, International Paper, Kohl's Corporation, Marathon Oil Corp., Marriott International Inc., Marvell Technology Group Ltd, McGraw-Hill Inc, Mediacom Communications Corporation, Merck, Merrill Lynch & Co., Metlife, Micron Technology, Microsoft Corporation, Mitsubishi Estate, Mitsui Fudosan, Morgan Stanley, National Australia Bank Ltd, New York Community Bancorp, Inc., News Corp, Nike Inc, Nokia Corporation, Nova Chemical, Nuance Communications Inc, Nucor Corp, NuStar Energy, L.P., Occidental Petroleum Corp., Omnicom Group Inc, Oshkosh Truck Corp, Pactiv Corp, PartnerRe Ltd., Pfizer, Philip Morris International, Pioneer Natural Resources, Pioneer Southwest Energy Partners L.P., Polaris Industries, Principal Financial Group, Inc., ProLogis, Qimonda AG, Raytheon Company, Rockwell Collins, Roper Industries Inc, SanDisk Corporation, Schering-Plough, Sempra Energy, Simon Property Group, Skyworks Solutions Inc, Sunoco, Inc, Terex Corporation, Terra Industries Inc, Tesoro Corporation, Texas Instruments, Textron, The Charles Schwab Corporation, Time Warner Inc, Timken Co, TW Telecom, Unibail-Rodamco, United Parcel Service Inc B, United Therapeutics Corp, UnitedHealth Group, Urban Outfitters Inc., Vale, Valeant Pharmaceuticals Holdings Inc., Valero Energy Corp, Varian Medical Systems Inc, Verizon Communications Inc., VF Corp, Vivendi Universal, Wal-Mart Stores, Inc., Waste Connections Inc., WellPoint, Inc., Westfield Group, Westpac Banking Corporation, Wisconsin Energy Corp, WPP Group plc and Wyeth in the past 12 months. Citigroup Global Markets Inc. currently has, or had within the past 12 months, the following company(ies) as investment banking client(s): AbitibiBowater Inc, Aetna, Inc., Alberto-Culver Co, Alexandria Real Estate Equities, Allegheny Energy Inc, Allergan Inc, Allstate Corporation, Altera Corporation, American Express Co, Amphenol, ANZ Banking Group Ltd, Aon Corporation, Apple Inc, Arch Capital Group Ltd., Avon Products, Bear Stearns Cos Inc, BlackRock, Inc, Blockbuster Inc, Bristol-Myers Squibb, Caterpillar, Inc., Celgene, China Coal Energy, Cisco Systems Inc, Commonwealth Bank of Aust. Ltd, ConAgra Foods, Coventry Health Care Inc, Covidien Ltd, Discover Financial Services, E.ON, Eastman Chemical, Eaton Corporation, EDF, Eli Lilly, Embarq Corporation, Equinix, Inc., Estee Lauder Companies Inc., Fannie Mae, FirstEnergy Corporation, Fiserv, Inc., Forest Oil Corporation, Freddie Mac, Gamestop Corp, Gaylord Entertainment, Genentech Inc, Google Inc, Health Net Inc, Hewlett-Packard, Hologic
58
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
Inc, Honeywell International, IHS, Inc., Intel Corporation, International Business Machines, International Paper, Kohl's Corporation, Marathon Oil Corp., Marriott International Inc., McGraw-Hill Inc, Merck, Merrill Lynch & Co., Metlife, Micron Technology, Microsoft Corporation, Mitsubishi Estate, Mitsui Fudosan, Morgan Stanley, National Australia Bank Ltd, News Corp, Nike Inc, Nokia Corporation, Nuance Communications Inc, Nucor Corp, NuStar Energy, L.P., Occidental Petroleum Corp., Omnicom Group Inc, PartnerRe Ltd., Pfizer, Philip Morris International, Pioneer Natural Resources, Pioneer Southwest Energy Partners L.P., Principal Financial Group, Inc., ProLogis, Qimonda AG, Raytheon Company, Rockwell Collins, Saks Incorporated, Schering-Plough, Sempra Energy, Simon Property Group, Spansion Inc, Sunoco, Inc, Terex Corporation, Terra Industries Inc, Texas Instruments, Textron, The Charles Schwab Corporation, Time Warner Inc, TW Telecom, United Parcel Service Inc B, United Therapeutics Corp, UnitedHealth Group, Vale, Valeant Pharmaceuticals Holdings Inc., Valero Energy Corp, Varian Medical Systems Inc, Verizon Communications Inc., VF Corp, Vivendi Universal, Wal-Mart Stores, Inc., Waste Connections Inc., WellPoint, Inc., Westfield Group, Westpac Banking Corporation, Wisconsin Energy Corp, WPP Group plc and Wyeth. Citigroup Global Markets Inc. currently has, or had within the past 12 months, the following company(ies) as clients, and the services provided were non-investment-banking, securities-related: AbitibiBowater Inc, Aetna, Inc., Albemarle Corp, Alberto-Culver Co, Alexandria Real Estate Equities, Allergan Inc, Allstate Corporation, Altera Corporation, Amdocs Limited, American Express Co, Amphenol, ANZ Banking Group Ltd, Aon Corporation, Apple Inc, Arch Capital Group Ltd., Avon Products, Bear Stearns Cos Inc, BlackRock, Inc, Blockbuster Inc, BorgWarner, Inc., Bristol-Myers Squibb, Broadcom Corporation, Caterpillar, Inc., Celgene, China Coal Energy, Cisco Systems Inc, Commonwealth Bank of Aust. Ltd, ConAgra Foods, Coventry Health Care Inc, Covidien Ltd, CVS Caremark Corp, Discover Financial Services, E.ON, Eastman Chemical, Eaton Corporation, EDF, Eli Lilly, Embarq Corporation, Equinix, Inc., Estee Lauder Companies Inc., Fannie Mae, FirstEnergy Corporation, Fiserv, Inc., Forest Oil Corporation, FormFactor, Freddie Mac, Gamestop Corp, Gaylord Entertainment, Genentech Inc, Google Inc, Health Net Inc, Hewlett-Packard, Honeywell International, IHS, Inc., Intel Corporation, International Business Machines, International Paper, Kohl's Corporation, Marathon Oil Corp., Marriott International Inc., Marvell Technology Group Ltd, McGraw-Hill Inc, Mediacom Communications Corporation, Merck, Merrill Lynch & Co., Metlife, Micron Technology, Microsoft Corporation, Mitsubishi Estate, Mitsui Fudosan, Morgan Stanley, National Australia Bank Ltd, New York Community Bancorp, Inc., News Corp, Nike Inc, Nokia Corporation, Nova Chemical, Nucor Corp, Occidental Petroleum Corp., Omnicom Group Inc, Oshkosh Truck Corp, Pactiv Corp, PartnerRe Ltd., Pfizer, Philip Morris International, Pioneer Natural Resources, Pioneer Southwest Energy Partners L.P., Principal Financial Group, Inc., ProLogis, Qimonda AG, Raytheon Company, Rockwell Collins, Roper Industries Inc, Saks Incorporated, SanDisk Corporation, Schering-Plough, Sempra Energy, Sunoco, Inc, Terex Corporation, Terra Industries Inc, Tesoro Corporation, Texas Instruments, Textron, The Charles Schwab Corporation, Time Warner Inc, TW Telecom, Unibail-Rodamco, United Parcel Service Inc B, United Therapeutics Corp, UnitedHealth Group, Urban Outfitters Inc., Vale, Valeant Pharmaceuticals Holdings Inc., Valero Energy Corp, Varian Medical Systems Inc, Verizon Communications Inc., VF Corp, Vivendi Universal, Wal-Mart Stores, Inc., Waste Connections Inc., WellPoint, Inc., Westfield Group, Westpac Banking Corporation, Wisconsin Energy Corp, WPP Group plc and Wyeth. Citigroup Global Markets Inc. currently has, or had within the past 12 months, the following company(ies) as clients, and the services provided were non-investment-banking, non-securities-related: AbitibiBowater Inc, Aetna, Inc., Albemarle Corp, Alberto-Culver Co, Alexandria Real Estate Equities, Allegheny Energy Inc, Allergan Inc, Allstate Corporation, Altera Corporation, Amdocs Limited, American Express Co, Amphenol, ANZ Banking Group Ltd, Aon Corporation, Apple Inc, Arch Capital Group Ltd., Avon Products, Bear Stearns Cos Inc, BlackRock, Inc, Blockbuster Inc, BorgWarner, Inc., Bristol-Myers Squibb, Broadcom Corporation, Caterpillar, Inc., Celgene, China Coal Energy, Cisco Systems Inc, Commonwealth Bank of Aust. Ltd, ConAgra Foods, Coventry Health Care Inc, Covidien Ltd, Discover Financial Services, E.ON, Eastman Chemical, Eaton Corporation, EDF, Eli Lilly, Embarq Corporation, Estee Lauder Companies Inc., Fannie Mae, FirstEnergy Corporation, Fiserv, Inc., Forest Oil Corporation, FormFactor, Freddie Mac, Gamestop Corp, Gaylord Entertainment, Genentech Inc, Google Inc, Health Net Inc, Hewlett-Packard, Hologic Inc, Honeywell International, IHS, Inc., Intel Corporation, International Business Machines, International Paper, Kohl's Corporation, Marathon Oil Corp., Marriott International Inc., Marvell Technology Group Ltd, McGraw-Hill Inc, Mediacom Communications Corporation, Merck, Merrill Lynch & Co., Metlife, Micron Technology, Microsoft Corporation, Mitsui Fudosan, Morgan Stanley, National Australia Bank Ltd, New York Community Bancorp, Inc., News Corp, Nike Inc, Nokia Corporation, Nova Chemical, Nuance Communications Inc, Nucor Corp, NuStar Energy, L.P., Occidental Petroleum Corp., Omnicom Group Inc, Oshkosh Truck Corp, Pactiv Corp, PartnerRe Ltd., Pfizer, Philip Morris International, Pioneer Natural Resources, Pioneer Southwest Energy Partners L.P., Polaris Industries, Principal Financial Group, Inc., ProLogis, Qimonda AG, Raytheon Company, Rockwell Collins, Roper Industries Inc, Schering-Plough, Sempra Energy, Simon Property Group, Skyworks Solutions Inc, Sunoco, Inc, Terex Corporation, Terra Industries Inc, Tesoro Corporation, Texas Instruments, Textron, The Charles Schwab Corporation, Time Warner Inc, Timken Co, TW Telecom, Unibail-Rodamco, United Parcel Service Inc B, United Therapeutics Corp, UnitedHealth Group, Vale, Valeant Pharmaceuticals Holdings Inc., Valero Energy Corp, Varian Medical Systems Inc, Verizon Communications Inc., VF Corp, Vivendi Universal, Wal-Mart Stores, Inc., Waste Connections Inc., WellPoint, Inc., Westfield Group, Westpac Banking Corporation, Wisconsin Energy Corp, WPP Group plc and Wyeth. Citigroup Global Markets Inc. or an affiliate received compensation in the past 12 months from AbitibiBowater Inc, Aetna, Inc., Albemarle Corp, Alexandria Real Estate Equities, Amdocs Limited, Amphenol, ANZ Banking Group Ltd, BlackRock, Inc, Blockbuster Inc, Celgene, China Coal Energy, Commonwealth Bank of Aust. Ltd, Eastman Chemical, Fannie Mae, FirstEnergy Corporation, Fiserv, Inc., IHS, Inc., Intel Corporation, Nova Chemical, Pioneer Southwest Energy Partners L.P., ProLogis, Qimonda AG, Sempra Energy, Spansion Inc, Terra Industries Inc, Texas Instruments, Urban Outfitters Inc., Vale, Vivendi Universal, Waste Connections Inc., Westpac Banking Corporation and WPP Group plc. Analysts' compensation is determined based upon activities and services intended to benefit the investor clients of Citigroup Global Markets Inc. and its affiliates ("the Firm"). Like all Firm employees, analysts receive compensation that is impacted by overall firm profitability, which includes revenues from, among other business units, the Private Client Division, Institutional Sales and Trading, and Investment Banking. The Firm is a market maker in the publicly traded equity securities of Altera Corporation, ANZ Banking Group Ltd, Apple Inc, Arch Capital Group Ltd., Broadcom Corporation, Celgene, Cisco Systems Inc, CVS Caremark Corp, Cynosure Inc, E.ON, Equinix, Inc., Fiserv, Inc., FormFactor, Google Inc, Hologic Inc, ImClone Systems, Intel Corporation, Marvell Technology Group Ltd, Mediacom Communications Corporation, Microsoft Corporation, Mitsubishi Estate, Morgan Stanley, National Australia Bank Ltd, Nuance Communications Inc, NuStar Energy, L.P., ON Semiconductor Corporation, SanDisk Corporation, Skyworks Solutions Inc, Spansion Inc, The Charles Schwab Corporation, THQ Inc, TW Telecom, United Natural Foods, Inc., United Therapeutics Corp, Urban Outfitters Inc. and WPP Group plc. For important disclosures (including copies of historical disclosures) regarding the companies that are the subject of this Citi Investment Research product ("the Product"), please contact Citi Investment Research, 388 Greenwich Street, 29th Floor, New York, NY, 10013, Attention: Legal/Compliance. In addition, the same important disclosures, with the exception of the Valuation and Risk assessments and historical disclosures, are contained on the Firm's disclosure website at www.citigroupgeo.com. Private Client Division clients should refer to www.smithbarney.com/research. Valuation and Risk assessments can be found in the text of the most recent research note/report regarding the subject company. Historical disclosures (for up to the past three years) will be provided upon request. Citi Investment Research Ratings Distribution Data current as of 30 June 2008 Citi Investment Research Global Fundamental Coverage (3096) % of companies in each rating category that are investment banking clients Citi Investment Research Quantitative World Radar Screen Model Coverage (9447) Buy 50% 53% 29% Hold 36% 52% 40% Sell 14% 42% 31%
59
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
% of companies in each rating category that are investment banking clients 27% 27% 26% Citi Investment Research Quantitative Decision Tree Model Coverage (324) 46% 0% 54% % of companies in each rating category that are investment banking clients 74% 0% 66% Citi Investment Research Quantitative European Value & Momentum Screen (594) 30% 40% 30% % of companies in each rating category that are investment banking clients 49% 54% 52% Citi Investment Research Asia Quantitative Radar Screen Model Coverage (2292) 20% 60% 20% % of companies in each rating category that are investment banking clients 31% 23% 21% Citi Investment Research Quant Multi-Factor Model Coverage (0) 0% 0% 0% % of companies in each rating category that are investment banking clients 0% 0% 0% Citi Investment Research Australia Quantitative Top 100 Model Coverage (100) 30% 40% 30% % of companies in each rating category that are investment banking clients 67% 73% 30% Citi Investment Research Australia Quantitative Bottom 200 Model Coverage (194) 30% 40% 30% % of companies in each rating category that are investment banking clients 12% 4% 20% Citi Investment Research Australia Quantitative Scoring Stocks Model Coverage (66) 50% 0% 50% % of companies in each rating category that are investment banking clients 39% 0% 24% Guide to Fundamental Research Investment Ratings: Citi Investment Research's stock recommendations include a risk rating and an investment rating. Risk ratings, which take into account both price volatility and fundamental criteria, are: Low (L), Medium (M), High (H), and Speculative (S). Investment ratings are a function of Citi Investment Research's expectation of total return (forecast price appreciation and dividend yield within the next 12 months) and risk rating. For securities in developed markets (US, UK, Europe, Japan, and Australia/New Zealand), investment ratings are: Buy (1) (expected total return of 10% or more for Low-Risk stocks, 15% or more for Medium-Risk stocks, 20% or more for High-Risk stocks, and 35% or more for Speculative stocks); Hold (2) (0%-10% for Low-Risk stocks, 0%-15% for Medium-Risk stocks, 0%-20% for High-Risk stocks, and 0%-35% for Speculative stocks); and Sell (3) (negative total return). For securities in emerging markets (Asia Pacific, Emerging Europe/Middle East/Africa, and Latin America), investment ratings are: Buy (1) (expected total return of 15% or more for Low-Risk stocks, 20% or more for Medium-Risk stocks, 30% or more for High-Risk stocks, and 40% or more for Speculative stocks); Hold (2) (5%-15% for Low-Risk stocks, 10%-20% for Medium-Risk stocks, 15%-30% for High-Risk stocks, and 20%-40% for Speculative stocks); and Sell (3) (5% or less for Low-Risk stocks, 10% or less for Medium-Risk stocks, 15% or less for High-Risk stocks, and 20% or less for Speculative stocks). Investment ratings are determined by the ranges described above at the time of initiation of coverage, a change in investment and/or risk rating, or a change in target price (subject to limited management discretion). At other times, the expected total returns may fall outside of these ranges because of market price movements and/or other short-term volatility or trading patterns. Such interim deviations from specified ranges will be permitted but will become subject to review by Research Management. Your decision to buy or sell a security should be based upon your personal investment objectives and should be made only after evaluating the stock's expected performance and risk. Guide to Corporate Bond Research Credit Opinions and Investment Ratings: Citi Investment Research's corporate bond research issuer publications include a fundamental credit opinion of Improving, Stable or Deteriorating and a complementary risk rating of Low (L), Medium (M), High (H) or Speculative (S) regarding the credit risk of the company featured in the report. The fundamental credit opinion reflects the CIR analyst's opinion of the direction of credit fundamentals of the issuer without respect to securities market vagaries. The fundamental credit opinion is not geared to, but should be viewed in the context of, debt ratings issued by major public debt ratings companies such as Moody's Investors Service, Standard and Poor's, and Fitch Ratings. CBR risk ratings are approximately equivalent to the following matrix: Low Risk -Triple A to Low Double A; Low to Medium Risk -- High Single A through High Triple B; Medium to High Risk -- Mid Triple B through High Double B; High to Speculative Risk -Mid Double B and Below. The risk rating element illustrates the analyst's opinion of the relative likelihood of loss of principal when a fixed income security issued by a company is held to maturity, based upon both fundamental and market risk factors. Certain reports published by Citi Investment Research will also include investment ratings on specific issues of companies under coverage which have been assigned fundamental credit opinions and risk ratings. Investment ratings are a function of Citi Investment Research's expectations for total return, relative return (relative to the performance of relevant Citi bond indices), and risk rating. These investment ratings are: Buy/Overweight -- the bond is expected to outperform the relevant Citigroup bond market sector index (Broad Investment Grade, High Yield Market or Emerging Market); Hold/Neutral Weight -- the bond is expected to perform in line with the relevant Citigroup bond market sector index; or Sell/Underweight -- the bond is expected to underperform the relevant Citigroup bond market sector index. Performance data for Citi bond indices are updated monthly, are available upon request and can also be viewed at http://sd.ny.ssmb.com/ using the "Indexes" tab. Guide to Quantitative Research Investment Ratings: Citi Investment Research Quantitative Research World Radar Screen recommendations are based on a globally consistent framework to measure relative value and momentum for a large number of stocks across global developed and emerging markets. Relative value and momentum rankings are equally weighted to produce a global attractiveness score for each stock. The scores are then ranked and put into deciles. A stock with a decile rating of 1 denotes an attractiveness score in the top 10% of the universe (most attractive). A stock with a decile rating of 10 denotes an attractiveness score in the bottom 10% of the universe (least attractive). Citi Investment Research Quantitative Decision Tree model recommendations are based on a predetermined set of factors to rate the relative attractiveness of stocks. These factors are detailed in the text of the report. Each month, the Decision Tree model forecasts whether stocks are attractive or unattractive relative to other stocks in the same sector (based on the Russell 1000 sector classifications). Citi Investment Research Quantitative European Value & Momentum Screen recommendations are based on a European consistent framework to measure relative value and momentum for a large number of stocks across the European Market. Relative value and momentum rankings are equally weighted to produce a European attractiveness score for each stock. The scores are then ranked and put into deciles. A stock with a decile rating of 1 denotes an attractiveness score in the top 10% of the universe (most attractive). A stock with a decile rating of 10 denotes an attractiveness score in the bottom 10% of the universe (least attractive). Citi Investment Research Asia Quantitative Radar Screen and Emerging Markets Radar Screen model recommendations are based on a regionally consistent framework to measure relative value and momentum for a large number of stocks across regional developed and emerging markets. Relative value and momentum rankings are equally weighted to produce a global attractiveness score for each stock. The scores are then ranked and put into quintiles. A stock with a quintile rating of 1 denotes an attractiveness score in the top 20% of the universe (most attractive). A stock with a quintile rating of 5 denotes an attractiveness score in the bottom 20% of the universe (least attractive). Citi Investment Research Quantitative Australian Stock Selection Screen rankings are based on a consistent framework to measure relative value and earnings momentum
60
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
for a large number of stocks across the Australian market. Relative value and earnings momentum rankings are weighted to produce a rank within a relevant universe for each stock. The rankings are then put into deciles. A stock with a decile rating of 1 denotes an attractiveness score in the top 10% of the universe (most attractive). A stock with a decile rating of 10 denotes an attractiveness score in the bottom 10% of the universe (least attractive). Citi Investment Research Quantitative Research Australian Scoring Stocks model recommendations are based on a predetermined set of factors to rate the relative attractiveness of stocks. These factors are detailed in the text of the report. Each month, the Australian Scoring Stocks model calculates whether stocks are attractive or unattractive relative to other stocks in the same universe(the S&P/ASX 100) and records the 5 most attractive buys and 5 most attractive sells on the basis of the criteria described in the report. For purposes of NASD/NYSE ratings-distribution-disclosure rules, a Citi Investment Research Quantitative World Radar Screen and European Value & Momentum Screen recommendation of (1), (2) or (3) most closely corresponds to a buy recommendation; a recommendation from this product group of (4), (5), (6) or (7) most closely corresponds to a hold recommendation; and a recommendation of (8), (9) or (10) most closely corresponds to a sell recommendation. For purposes of NASD/NYSE ratings distribution disclosure rules, a Citi Investment Research Asia Quantitative Radar Screen or Quantitative Emerging Markets Radar Screen recommendation of (1) most closely corresponds to a buy recommendation; a Citi Investment Research Asia Quantitative Radar Screen or Quantitative Emerging Markets Radar Screen recommendation of (2), (3), (4) most closely corresponds to a hold recommendation; and a recommendation of (5) most closely corresponds to a sell recommendation. For purposes of NASD/NYSE ratings-distribution-disclosure rules, a Citi Investment Research Quantitative Research Decision Tree model recommendation of "attractive" most closely corresponds to a buy recommendation. All other stocks in the sector are considered to be "unattractive" which most closely corresponds to a sell recommendation. Recommendations are based on the relative attractiveness of a stock, they can not be directly equated to buy, hold and sell categories. Accordingly, your decision to buy or sell a security should be based on your personal investment objectives and only after evaluating the stock's expected relative performance. For purposes of NASD/NYSE ratings-distribution-disclosure rules, a Citi Investment Research Quantitative Australian Stock Selection Screen model ranking in the top third of the universe most closely corresponds, subject to market conditions, to a buy recommendation. A ranking in the bottom third of the universe, subject to market conditions, most closely corresponds to a sell recommendation. All other stocks in the universe correspond to a hold recommendation. However, because Citi Investment Research Quantitative Australian Stock Selection Screen model rankings are based on the relative attractiveness of a stock as compared to other stocks in the same universe, they can not be directly equated to buy, hold and sell categories. Accordingly, your decision to buy or sell a security should be based on your personal investment objectives and only after evaluating the stock's expected absolute performance. For purposes of NASD/NYSE ratings-distribution-disclosure rules, membership of the Citi Investment Research Quantitative Australian Scoring Stocks Model buy portfolio most closely corresponds to a buy recommendation; membership of the Citi Investment Research Quantitative Australian Scoring Stocks Model sell portfolio most closely corresponds to a sell recommendation. However, because Citi Investment Research Quantitative Australian Scoring Stocks Model recommendations are based on the relative attractiveness of a stock, they can not be directly equated to buy, hold and sell categories. Accordingly, your decision to buy or sell a security should be based on your personal investment objectives and only after evaluating the stock's expected absolute performance.
OTHER DISCLOSURES
Citigroup Global Markets Inc. and/or its affiliates has a significant financial interest in relation to AbitibiBowater Inc, Aetna, Inc., Alexandria Real Estate Equities, Allegheny Energy Inc, Allergan Inc, Allstate Corporation, Altera Corporation, American Express Co, Aon Corporation, Avon Products, Bear Stearns Cos Inc, BlackRock, Inc, BorgWarner, Inc., Bristol-Myers Squibb, Caterpillar, Inc., Cisco Systems Inc, Commonwealth Bank of Aust. Ltd, ConAgra Foods, Coventry Health Care Inc, Covidien Ltd, CVS Caremark Corp, Discover Financial Services, E.ON, Eastman Chemical, Eaton Corporation, Embarq Corporation, Equinix, Inc., Estee Lauder Companies Inc., Fannie Mae, FirstEnergy Corporation, Forest Oil Corporation, Freddie Mac, Gamestop Corp, Genentech Inc, Health Net Inc, Hewlett-Packard, Honeywell International, IHS, Inc., Intel Corporation, International Business Machines, International Paper, Kohl's Corporation, Marathon Oil Corp., Marriott International Inc., McGraw-Hill Inc, Mediacom Communications Corporation, Merck, Merrill Lynch & Co., Metlife, Morgan Stanley, National Australia Bank Ltd, News Corp, Nike Inc, Nokia Corporation, Nova Chemical, Nucor Corp, Occidental Petroleum Corp., Omnicom Group Inc, Oshkosh Truck Corp, Pactiv Corp, PartnerRe Ltd., Pfizer, Pioneer Natural Resources, Principal Financial Group, Inc., ProLogis, Raytheon Company, Rockwell Collins, Roper Industries Inc, Saks Incorporated, SanDisk Corporation, Schering-Plough, Sempra Energy, Simon Property Group, Sunoco, Inc, Terex Corporation, Terra Industries Inc, Tesoro Corporation, Texas Instruments, Textron, The Charles Schwab Corporation, Time Warner Inc, United Parcel Service Inc B, UnitedHealth Group, Vale, Valero Energy Corp, Verizon Communications Inc., VF Corp, Vivendi Universal, Wal-Mart Stores, Inc., WellPoint, Inc., Westfield Group, Westpac Banking Corporation, Wisconsin Energy Corp, WPP Group plc and Wyeth. (For an explanation of the determination of significant financial interest, please refer to the policy for managing conflicts of interest which can be found at www.citigroupgeo.com.) Citigroup Global Markets Inc. or its affiliates beneficially owns 2% or more of any class of common equity securities of AbitibiBowater Inc, ANZ Banking Group Ltd, Fannie Mae, Freddie Mac, Merrill Lynch & Co., Microsoft Corporation, News Corp, SanDisk Corporation, Tesoro Corporation, United Therapeutics Corp, Vale, Westpac Banking Corporation and Yanzhou Coal Mining. Citigroup Global Markets Inc. or its affiliates beneficially owns 5% or more of any class of common equity securities of Nova Chemical and Saks Incorporated. Citigroup Global Markets Inc. or its affiliates beneficially owns 10% or more of any class of common equity securities of American Express Co, Apple Inc, Commonwealth Bank of Aust. Ltd, Hewlett-Packard, National Australia Bank Ltd, PartnerRe Ltd. and Schering-Plough. For securities recommended in the Product in which the Firm is not a market maker, the Firm is a liquidity provider in the issuers' financial instruments and may act as principal in connection with such transactions. The Firm is a regular issuer of traded financial instruments linked to securities that may have been recommended in the Product. The Firm regularly trades in the securities of the subject company(ies) discussed in the Product. The Firm may engage in securities transactions in a manner inconsistent with the Product and, with respect to securities covered by the Product, will buy or sell from customers on a principal basis. Securities recommended, offered, or sold by the Firm: (i) are not insured by the Federal Deposit Insurance Corporation; (ii) are not deposits or other obligations of any insured depository institution (including Citibank); and (iii) are subject to investment risks, including the possible loss of the principal amount invested. Although information has been obtained from and is based upon sources that the Firm believes to be reliable, we do not guarantee its accuracy and it may be incomplete and condensed. Note, however, that the Firm has taken all reasonable steps to determine the accuracy and completeness of the disclosures made in the Important Disclosures section of the Product. The Firm's research department has received assistance from the subject company(ies) referred to in this Product including, but not limited to, discussions with management of the subject company(ies). Firm policy prohibits research analysts from sending draft research to subject companies. However, it should be presumed that the author of the Product has had discussions with the subject company to ensure factual accuracy prior to publication. All opinions, projections and estimates constitute the judgment of the author as of the date of the Product and these, plus any other information contained in the Product, are subject to change without notice. Prices and availability of financial instruments also are subject to change without notice. Notwithstanding other departments within the Firm advising the
61
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
companies discussed in this Product, information obtained in such role is not used in the preparation of the Product. Although Citi Investment Research does not set a predetermined frequency for publication, if the Product is a fundamental research report, it is the intention of Citi Investment Research to provide research coverage of the/those issuer(s) mentioned therein, including in response to news affecting this issuer, subject to applicable quiet periods and capacity constraints. The Product is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of a security. Any decision to purchase securities mentioned in the Product must take into account existing public information on such security or any registered prospectus. Investing in non-U.S. securities, including ADRs, may entail certain risks. The securities of non-U.S. issuers may not be registered with, nor be subject to the reporting requirements of the U.S. Securities and Exchange Commission. There may be limited information available on foreign securities. Foreign companies are generally not subject to uniform audit and reporting standards, practices and requirements comparable to those in the U.S. Securities of some foreign companies may be less liquid and their prices more volatile than securities of comparable U.S. companies. In addition, exchange rate movements may have an adverse effect on the value of an investment in a foreign stock and its corresponding dividend payment for U.S. investors. Net dividends to ADR investors are estimated, using withholding tax rates conventions, deemed accurate, but investors are urged to consult their tax advisor for exact dividend computations. Investors who have received the Product from the Firm may be prohibited in certain states or other jurisdictions from purchasing securities mentioned in the Product from the Firm. Smith Barney clients can ask their Financial Advisor for additional details. Citigroup Global Markets Inc. takes responsibility for the Product in the United States. Any orders by US investors resulting from the information contained in the Product may be placed only through Citigroup Global Markets Inc. The Citigroup legal entity that takes responsibility for the production of the Product is the legal entity which the first named author is employed by. The Product is made available in Australia to wholesale clients through Citigroup Global Markets Australia Pty Ltd. (ABN 64 003 114 832 and AFSL No. 240992) and to retail clients through Citi Smith Barney Pty Ltd. (ABN 19 009 145 555 and AFSL No. 240813), Participants of the ASX Group and regulated by the Australian Securities & Investments Commission. Citigroup Centre, 2 Park Street, Sydney, NSW 2000. The Product is made available in Australia to Private Banking wholesale clients through Citigroup Pty Limited (ABN 88 004 325 080 and AFSL 238098). Citigroup Pty Limited provides all financial product advice to Australian Private Banking wholesale clients through bankers and relationship managers. If there is any doubt about the suitability of investments held in Citigroup Private Bank accounts, investors should contact the Citigroup Private Bank in Australia. Citigroup companies may compensate affiliates and their representatives for providing products and services to clients. The Product is made available in Brazil by Citigroup Global Markets Brasil - CCTVM SA, which is regulated by CVM - Comissão de Valores Mobiliários, BACEN - Brazilian Central Bank, APIMEC Associação Associação dos Analistas e Profissionais de Investimento do Mercado de Capitais and ANBID - Associação Nacional dos Bancos de Investimento. Av. Paulista, 1111 - 11º andar - CEP. 01311920 - São Paulo - SP. If the Product is being made available in certain provinces of Canada by Citigroup Global Markets (Canada) Inc. ("CGM Canada"), CGM Canada has approved the Product. Citigroup Place, 123 Front Street West, Suite 1100, Toronto, Ontario M5J 2M3. The Product is made available in France by Citigroup Global Markets Limited, which is authorised and regulated by Financial Services Authority. 1-5 Rue Paul Cézanne, 8ème, Paris, France. The Product may not be distributed to private clients in Germany. The Product is distributed in Germany by Citigroup Global Markets Deutschland AG & Co. KGaA, which is regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin). Frankfurt am Main, Reuterweg 16, 60323 Frankfurt am Main. If the Product is made available in Hong Kong by, or on behalf of, Citigroup Global Markets Asia Ltd., it is attributable to Citigroup Global Markets Asia Ltd., Citibank Tower, Citibank Plaza, 3 Garden Road, Hong Kong. Citigroup Global Markets Asia Ltd. is regulated by Hong Kong Securities and Futures Commission. If the Product is made available in Hong Kong by The Citigroup Private Bank to its clients, it is attributable to Citibank N.A., Citibank Tower, Citibank Plaza, 3 Garden Road, Hong Kong. The Citigroup Private Bank and Citibank N.A. is regulated by the Hong Kong Monetary Authority. The Product is made available in India by Citigroup Global Markets India Private Limited, which is regulated by Securities and Exchange Board of India. Bakhtawar, Nariman Point, Mumbai 400-021. The Product is made available in Indonesia through PT Citigroup Securities Indonesia. 5/F, Citibank Tower, Bapindo Plaza, Jl. Jend. Sudirman Kav. 54-55, Jakarta 12190. Neither this Product nor any copy hereof may be distributed in Indonesia or to any Indonesian citizens wherever they are domiciled or to Indonesian residents except in compliance with applicable capital market laws and regulations. This Product is not an offer of securities in Indonesia. The securities referred to in this Product have not been registered with the Capital Market and Financial Institutions Supervisory Agency (BAPEPAM-LK) pursuant to relevant capital market laws and regulations, and may not be offered or sold within the territory of the Republic of Indonesia or to Indonesian citizens through a public offering or in circumstances which constitute an offer within the meaning of the Indonesian capital market laws and regulations. The Product is made available in Italy by Citigroup Global Markets Limited, which is authorised and regulated by Financial Services Authority. Foro Buonaparte 16, Milan, 20121, Italy. If the Product was prepared by Citi Investment Research and distributed in Japan by Nikko Citigroup Limited ("NCL"), it is being so distributed under license. If the Product was prepared by NCL and distributed by Nikko Cordial Securities Inc. or Citigroup Global Markets Inc. it is being so distributed under license. NCL is regulated by Financial Services Agency, Securities and Exchange Surveillance Commission, Japan Securities Dealers Association, Tokyo Stock Exchange and Osaka Securities Exchange. Shin-Marunouchi Building, 1-5-1 Marunouchi, Chiyoda-ku, Tokyo 100-6520 Japan. In the event that an error is found in an NCL research report, a revised version will be posted on Citi Investment Research's Global Equities Online (GEO) website. If you have questions regarding GEO, please call (81 3) 6270-3019 for help. The Product is made available in Korea by Citigroup Global Markets Korea Securities Ltd., which is regulated by Financial Supervisory Commission and the Financial Supervisory Service. Hungkuk Life Insurance Building, 226 Shinmunno 1-GA, Jongno-Gu, Seoul, 110-061. The Product is made available in Malaysia by Citigroup Global Markets Malaysia Sdn Bhd, which is regulated by Malaysia Securities Commission. Menara Citibank, 165 Jalan Ampang, Kuala Lumpur, 50450. The Product is made available in Mexico by Acciones y Valores Banamex, S.A. De C. V., Casa de Bolsa, which is regulated by Comision Nacional Bancaria y de Valores. Reforma 398, Col. Juarez, 06600 Mexico, D.F. In New Zealand the Product is made available through Citigroup Global Markets New Zealand Ltd. (Company Number 604457), a Participant of the New Zealand Exchange Limited and regulated by the New Zealand Securities Commission. Level 19, Mobile on the Park, 157 Lambton Quay, Wellington. The Product is made available in Pakistan by Citibank N.A. Pakistan branch, which is regulated by the State Bank of Pakistan and Securities Exchange Commission, Pakistan. AWT Plaza, 1.1. Chundrigar Road, P.O. Box 4889, Karachi-74200. The Product is made available in Poland by Dom Maklerski Banku Handlowego SA an indirect subsidiary of Citigroup Inc., which is regulated by Komisja Papierów Wartosciowych i Gield. Bank Handlowy w Warszawie S.A. ul. Senatorska 16, 00-923 Warszawa. The Product is made available in the Russian Federation through ZAO Citibank, which is licensed to carry out banking activities in the Russian Federation in accordance with the general banking license issued by the Central Bank of the Russian Federation and brokerage activities in accordance with the license issued by the Federal Service for Financial Markets. Neither the Product nor any information contained in the Product shall be considered as advertising the securities mentioned in this report within the territory of the Russian Federation or outside the Russian Federation. The Product does not constitute an appraisal within the meaning of the Federal Law of the Russian Federation of 29 July 1998 No. 135-FZ (as amended) On Appraisal Activities in the Russian Federation. 8-10 Gasheka Street, 125047 Moscow. The Product is made available in Singapore through Citigroup Global Markets Singapore Pte. Ltd., a Capital Markets Services Licence holder, and regulated by Monetary Authority of Singapore. 1 Temasek Avenue, #39-02 Millenia Tower, Singapore 039192. The Product is made available by The Citigroup Private Bank in Singapore through Citibank, N.A., Singapore branch, a licensed bank in Singapore that is regulated by Monetary Authority of Singapore. Citigroup Global Markets (Pty) Ltd. is incorporated in the Republic of South Africa (company registration number 2000/025866/07) and its registered office is at 145 West Street, Sandton, 2196, Saxonwold. Citigroup Global Markets (Pty) Ltd. is regulated by JSE Securities Exchange South Africa, South African Reserve Bank and the Financial Services Board. The investments and services contained herein are not available to private customers in South Africa. The Product is made available in Spain by Citigroup Global Markets Limited, which is authorised and regulated by Financial Services Authority. 29 Jose Ortega Y Gassef, 4th Floor, Madrid, 28006, Spain. The Product is made available in Taiwan through Citigroup Global Markets Inc. (Taipei Branch), which is regulated by Securities & Futures Bureau. No portion of the report may be reproduced or quoted in Taiwan by the press or any other person. No. 8 Manhattan Building, Hsin Yi Road, Section 5, Taipei
62
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
100, Taiwan. The Product is made available in Thailand through Citicorp Securities (Thailand) Ltd., which is regulated by the Securities and Exchange Commission of Thailand. 18/F, 22/F and 29/F, 82 North Sathorn Road, Silom, Bangrak, Bangkok 10500, Thailand. The Product is made available in Turkey through Citibank AS which is regulated by Capital Markets Board. Tekfen Tower, Eski Buyukdere Caddesi # 209 Kat 2B, 23294 Levent, Istanbul, Turkey. The Product is made available in U.A.E. by Citigroup Global Markets Limited, which is authorised and regulated by Financial Services Authority. DIFC, Bldg 2, Level 7, PO Box 506560, Dubai, UAE. The Product is made available in United Kingdom by Citigroup Global Markets Limited, which is authorised and regulated by Financial Services Authority. This material may relate to investments or services of a person outside of the UK or to other matters which are not regulated by the FSA and further details as to where this may be the case are available upon request in respect of this material. Citigroup Centre, Canada Square, Canary Wharf, London, E14 5LB. The Product is made available in United States by Citigroup Global Markets Inc, which is regulated by NASD, NYSE and the US Securities and Exchange Commission. 388 Greenwich Street, New York, NY 10013. Unless specified to the contrary, within EU Member States, the Product is made available by Citigroup Global Markets Limited, which is regulated by Financial Services Authority. Many European regulators require that a firm must establish, implement and make available a policy for managing conflicts of interest arising as a result of publication or distribution of investment research. The policy applicable to Citi Investment Research's Products can be found at www.citigroupgeo.com. Compensation of equity research analysts is determined by equity research management and Citigroup's senior management and is not linked to specific transactions or recommendations. The Product may have been distributed simultaneously, in multiple formats, to the Firm's worldwide institutional and retail customers. The Product is not to be construed as providing investment services in any jurisdiction where the provision of such services would not be permitted. Subject to the nature and contents of the Product, the investments described therein are subject to fluctuations in price and/or value and investors may get back less than originally invested. Certain high-volatility investments can be subject to sudden and large falls in value that could equal or exceed the amount invested. Certain investments contained in the Product may have tax implications for private customers whereby levels and basis of taxation may be subject to change. If in doubt, investors should seek advice from a tax adviser. The Product does not purport to identify the nature of the specific market or other risks associated with a particular transaction. Advice in the Product is general and should not be construed as personal advice given it has been prepared without taking account of the objectives, financial situation or needs of any particular investor. Accordingly, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to their objectives, financial situation and needs. Prior to acquiring any financial product, it is the client's responsibility to obtain the relevant offer document for the product and consider it before making a decision as to whether to purchase the product. © 2008 Citigroup Global Markets Inc. (© Nikko Citigroup Limited, if this Product was prepared by it). Citi Investment Research is a division and service mark of Citigroup Global Markets Inc. and its affiliates and is used and registered throughout the world. Citi and Citi with Arc Design are trademarks and service marks of Citigroup Inc and its affiliates and are used and registered throughout the world. Nikko is a registered trademark of Nikko Cordial Corporation. All rights reserved. Any unauthorized use, duplication, redistribution or disclosure is prohibited by law and will result in prosecution. Where included in this report, MSCI sourced information is the exclusive property of Morgan Stanley Capital International Inc. (MSCI). Without prior written permission of MSCI, this information and any other MSCI intellectual property may not be reproduced, redisseminated or used to create any financial products, including any indices. This information is provided on an "as is" basis. The user assumes the entire risk of any use made of this information. MSCI, its affiliates and any third party involved in, or related to, computing or compiling the information hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to any of this information. Without limiting any of the foregoing, in no event shall MSCI, any of its affiliates or any third party involved in, or related to, computing or compiling the information have any liability for any damages of any kind. MSCI, Morgan Stanley Capital International and the MSCI indexes are services marks of MSCI and its affiliates. The information contained in the Product is intended solely for the recipient and may not be further distributed by the recipient. The Firm accepts no liability whatsoever for the actions of third parties. The Product may provide the addresses of, or contain hyperlinks to, websites. Except to the extent to which the Product refers to website material of the Firm, the Firm has not reviewed the linked site. Equally, except to the extent to which the Product refers to website material of the Firm, the Firm takes no responsibility for, and makes no representations or warranties whatsoever as to, the data and information contained therein. Such address or hyperlink (including addresses or hyperlinks to website material of the Firm) is provided solely for your convenience and information and the content of the linked site does not in anyway form part of this document. Accessing such website or following such link through the Product or the website of the Firm shall be at your own risk and the Firm shall have no liability arising out of, or in connection with, any such referenced website. ADDITIONAL INFORMATION IS AVAILABLE UPON REQUEST
63
Citigroup Global Markets Equity Research
US Portfolio Strategist 24 July 2008
U.S. Equity Research
Jonathan Rosenzweig — Director of Research Americas jonathan.rosenzweig@citi.com 212-816-3284 Jon V. Rogers — Deputy Director of Research Americas jon.v.rogers@citi.com 212-816-5274
Macro & Other
Chief U.S. Equity Strategist Tobias M. Levkovich Chief Global Equity Strategist Robert Buckland Quantitative Research Keith L. Miller Jonathan Barden John G. Rowe Aline Sun Options Strategy Mitchell S. Revsine Closed-End Funds—U.S. Dennis P. Emanuel Frank Sileo, CFA Kathy A. Jones Economic & Market Analysis Steven Wieting Data Services Javier Guardo, CFA 212-816-1623 44-20-7986-3947 212-816-2285 212-816-6033 212-816-6054 212-816-7083 212-816-6485 212-816-3356 212-816-5041 212-816-6008 212-816-7148 212-816-4683
Energy, Utilities, Industrials, Materials, Health Care, and REITs
Kathleen Boyle, CFA — Associate Director 212-816-3608
Energy
Alternative / Renewable Energy Timothy M. Arcuri Oil—Exploration & Production Gil Yang Oils—Integrated Faisel Khan, CFA Oilfield Equipment & Services Robin Shoemaker 415-951-1734 212-816-5803 212-816-2825 212-816-3258
Materials
Chemicals P. J. Juvekar 212-816-3097 Basic Materials Brian Yu, CFA 415-951-1830 Mining & Precious Metals John H. Hill, CFA 415-951-1714 Paper & Forest Products / Containers & Pkg. Chip Dillon, CFA 212-816-2793 Timothy Thein, CFA 212-816-6706
Utilities
Electric Utilities Greg Gordon, CFA 212-816-2802 Integrated Natural Gas & Gas Utilities Faisel Khan, CFA 212-816-2825 Merchant Power Brian Chin, CPA 212-816-2861
Health Care
Biotechnology Yaron Werber, MD 212-816-8836 Lucy Lu, MD 212-816-1441 Drugs John Boris 212-816-1635 Health Care Facilities Gary Taylor 212-816-0975 Health Care Policy Paul Heldman 202-879-6809 Managed Care / Health Care Distribution / IT Charles Boorady 212-816-7539 Medical Supplies & Technology Matthew J. Dodds 212-816-6928 Amit Bhalla 212-816-4069 Ophthalmology Amit Bhalla 212-816-4069 John Boris 212-816-1635
Industrials
Aerospace & Defense George D. Shapiro 212-816-3421 Air Transportation Andrew Light 44-20-7986-4102 Autos & Auto Parts Itay Michaeli 212-816-4557 Engineering & Construction Brian Chin, CPA 212-816-2861 Environmental Svcs / Business Svcs & Staffing Leone T. Young 212-816-1627 Machinery David Raso 212-816-6745 Multi-Industry / Electrical Equipment Jeffrey T. Sprague, CFA 203-975-5051
Small & Mid-Cap Research
Small & Mid-Cap Strategist Lori E. Calvasina
Biotechnology Lucy Lu, MD Electronic Payments Patrick M. Burton, CFA Electronic Design & Development Terence Whalen Insurance—Life Keith F. Walsh Insurance—Non-Life Joshua D. Shanker Leisure Gregory R. Badishkanian Medical Supplies & Technology Amit Bhalla 212-816-6499 212-816-1441 212-816-3469 415-951-1738 212-816-5452 212-816-2973 212-816-2720 212-816-4069
Real Estate Investment Trusts (REITs)
Michael Bilerman Ambika Goel Irwin Guzman John K. Tysseland Richard Roy 212-816-1383 212-816-6981 212-816-1685 212-816-1442 212-816-4870
MLPs, GPs, & Royalty Trust Partnerships
Consumer, Financials, Technology, Media, and Telecommunications
Michael Artura — Associate Director 415-951-1651
Consumer Discretionary
Apparel / Footwear / Textiles Kate McShane, CFA Gaming & Lodging Joshua Attie Leisure Gregory R. Badishkanian Retailing—Broadlines Deborah L. Weinswig Retailing—Hardlines Kate McShane, CFA Retailing—Softlines Kimberly Greenberger, CFA 212-816-3537 212-816-1533 212-816-2720 212-816-1860 212-816-3537 212-816-6409 212-816-8216 212-816-0440 212-816-3033 212-816-1815 212-816-1682 212-816-5452 212-816-2973 212-816-0502 212-816-2971 212-816-3593
Technology
Computer Services and IT Consulting Patrick M. Burton, CFA 212-816-3469 Ashwin Shirvaikar, CFA 212-816-0822 Data Networking & Storage Infrastructure Paul Mansky 415-951-1668 Electronic Design & Development Terence Whalen 415-951-1738 Telecom Equipment / EMS Jim Suva, CPA 415-951-1703 Electronic Payments Patrick M. Burton, CFA 212-816-3469 Imaging & Visual Media Matthew Troy 212-816-9051 PCs / Server & Enterprise Hardware Richard Gardner 415-951-1669 Semiconductors Glen S.P. Yeung 415-951-1885 Semiconductors—Specialty Craig A. Ellis 415-951-1887 Semiconductor Equipment Timothy M. Arcuri 415-951-1734 Software Brent Thill 415-951-1770
Corporate Bond Research
Director of Corporate Bond Research Cynthia Harlow 212-816-9187 Autos & Auto Parts Itay Michaeli 212-816-4557 Banks & Brokers Ryan O'Connell 212-816-8669 Basic Industries Richard Yu 212-816-9941 Consumer Products, Food & Beverage, Retail Julie Hung Fischer 212-816-1717 Energy & Utilities Denise Furey 212-816-6039 Homebuilders Julie Hung Fischer 212-816-1717 Media/Cable and Telecommunications David Hamburger 212-816-0442
Consumer Staples
Cosmetics / Household Products Wendy C. Nicholson Food Manufacturers David Driscoll, CFA
Financials
Banks Keith Horowitz, CFA Brokers & Asset Managers Prashant A. Bhatia, CFA Insurance—Life Colin W. Devine, CFA, CMA Keith F. Walsh Insurance—Non-Life Joshua D. Shanker Regional Banks Greg Ketron Specialty / Mortgage REITs Donald Fandetti, CFA Specialty / Mortgage Finance Bradley Ball
Media
Broadcasting & Entertainment Services Tony Wible, CFA 212-816-3732 Cable, Satellite, and Entertainment Jason B. Bazinet 212-816-6395 Internet Mark S. Mahaney 415-951-1744 Publishing & Advertising Catriona Fallon 415-951-1756
Product Management
Archibald Foster Andrew St. Pierre 212-816-8818 212-816-5101
Telecommunications
Wireless & Wireline Services Michael I. Rollins, CFA Erin E. Schmitz, CFA 212-816-1116 212-816-0086
64
Citigroup Global Markets Equity Research